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.
It will undoubtedly take time to know whether Europe’s leaders have succeeded on this occasion in their latest attempt to restore confidence. Nonetheless, with world equity markets up less than 5% year-to-date, but more importantly, with global economic growth forecasts being revised down, industrial output falling, unemployment rising in almost every major economy and fund manager cash balances at elevated levels, the need to act decisively is clear. The problems are well-known. So are the solutions (namely, policies to restore growth while reducing debt). The challenge is how to move as seamlessly as possible away from the former to the latter. The process will likely be long and almost certainly painful, but expectations are set low, at least providing some potential for a rerating. Correspondingly, all asset classes are likely to remain volatile. For now, we prefer to avoid Europe and see better asset allocation opportunities elsewhere, namely in selected US/ global equities, in EM and high yield credit, and also in a number of alternative asset managers.
First, the good news. The most recent EU Summit (the fourth this year) did result in some tangible progress rather than just the standard empty phrases which had become all too familiar. Crucially, it would seem that Germany is beginning to acquiesce, realising that it must be more accommodative in its policy stance if the European project is to be saved. The move to recapitalise banks directly with bailout funds (from the European Financial Stability Facility and the European Stability Mechanism) once Europe sets up a single banking regulator can perhaps be seen as akin to the Troubled Asset Relief Programme (TARP) initiated by the US Government in October 2008 at the nadir of the financial crisis to purchase assets and equity directly from financial institutions. If it works, then it could be significant, as it would help break the link between banking and sovereign problems. To this end, even if confidence alone is improved, then this ought to be seen as an encouraging step.
However, a more detailed assessment of the policy initiatives reveals (at least) two significant interlinked issues. If we accept that the need to act decisively is crucial, then timing and execution clearly matter. The reality is that all of Europe’s national Governments still need to approve Europe’s proposed banking union and the direct bank recapitalisation programme. This may not occur with any rapidity. Meanwhile, sentiment – and particularly when viewed in terms of equity market returns – may not simply recover immediately. Consider that markets fell for six consecutive months (with the S&P losing 20%) before recovering once TARP had been announced. Similarly, although European markets rose 10% in the two months after the commencement of the Long-term Refinancing Operation (LTRO), all of these gains were given back in the following two months.
The stark reality remains that there is too much debt globally. This is an issue both for governments and for banks (according to JP Morgan, more than one-third of all OECD banks are at ‘distressed’ levels, with credit spreads more than 3% above risk-free interest rates) – and it becomes a clear impediment to growth. As Rogoff and Reinhart demonstrate in their important and detailed study, This Time Is Different, where nations have public debt at levels of greater than 90% of GDP, they suffer a 1% lower median growth rate to their economies.
We can already see the evidence of deteriorating growth across the world. Notably, last month the Federal Reserve revised downward its 2012 US GDP estimate by 0.5% relative to the forecast made in April, while June’s ISM figure signalled economic contraction for the first time since July 2009. US Jobless claims last month were also at their highest since the start of the year. In Europe, the Purchasing Managers’ Index has fallen for eleven consecutive months and manufacturing output in Germany, the continent’s largest economy, is at a 36-month low. In China, the picture is only a little better, with eight consecutive months of industrial output decline and bank deposit growth at all-time lows. It is also notable that a wide and growing number of companies (and even ‘defensive’ staples businesses such as Danone and Procter & Gamble) have warned on the outlook even before the Q2 reporting season has begun.
It seems clear that policy needs to recognise data; namely, that the growth outlook has deteriorated. Importantly, without growth, fiscal austerity does not work. Or, as PIMCO’s Bill Gross puts it, you cannot cure debt with more debt. A detailed IMF study comprising 173 cases of budget cuts in varying countries across the world highlighted economic contraction in every case that austerity was attempted, it resulted in economic contraction. All roads therefore lead back to Central Banks (and additionally in Europe for the need to mutualise its debt – since it is the distribution of this debt across the continent rather than the quantity per se that is the issue. Notably this was not discussed at the recent Summit).
Do not read too much into the Fed’s decision to extend its Operation Twist policy of buying long-dated debt in order to flatten the yield curve. While it is both helpful and logical, more than anything, it buys the Fed time until there is more clarity on the growth outlook (and also until after the November Presidential Election). Critically, it also enables the Fed to save the QE ‘bullet’ until things get really bad. Similarly, the ECB (and even the Bank of England, based on its recent statements) still have ammunition available, allowing them to cut interest rates in the near-term. Co-ordinated money printing by Central Banks globally remains very possible. This, more than anything, could help restore sentiment and risk appetite as well as growth prospects.
The case for global quantitative easing is only enhanced by the current absence of inflation in almost all regions, helped by a stronger US Dollar and also by oil and food prices down more than 15% year-to-date. Latest inflation readings are 1.7% for the US, 2.0% for the Eurozone (with Germany at 1.7%), 2.8% for the UK (its lowest in two years) and just 3.0% even in China. With inflation seemingly under control for now, policymakers may be willing to take more risks. We have written about inflation in the past, believe its emergence will not be obvious and its progression far from linear, but – along with several other commentators (such as John Mauldin and Eclectica’s Hugh Hendry) – recognise that before we get significant money printing-induced inflation, deflation is probable. Recessions and deleveraging are deflationary events.
With uncertainty potentially set to dominate for much of the rest of the year, we believe it is more an issue of when rather than if policymakers act. It is worth recalling that equities had to fall more than 30% from their peaks before the Fed embarked on its initial round of quantitative easing; equities are currently down less than 15% from their peaks. Many tests still need to be confronted. In Europe, while investors are currently basking in post-Summit euphoria, it seems more than likely that Greece will have to hold further elections before the year-end; there are Dutch elections scheduled for September, and also in Italy early next year. Spain may also find it difficult to move forward, with GDP currently contracting at more than 2% and unemployment stuck firmly over 20%. Targeted fiscal retrenchment for 2012 is equivalent to 6% of GDP.
In the US, with the Presidential Election now less than five months’ away, it will dominate increasingly. Corporates may be sitting on record cash balances ($1.4 trillion in aggregate, according to JP Morgan), but they are unlikely to spend decisively until after the Election. Admittedly housing market trends are highly encouraging (median prices have risen for seven consecutive months and NAHB builder confidence is its highest in five years), but many of the improving dynamics of the US economy (industrial renaissance, shale gas, ‘smart’ manufacturing) are, in reality, unlikely to be game-changers this year. Nonetheless, solid foundations are being put in place to drive medium-term growth prospects.
Finally, turning to Asia, trends are mixed. For China, it is not just the question of managing the current slowdown and controlling a potentially over-heating property market, but also ensuring a smooth transition of power in October and the effective formation of new policy to drive future growth. Elsewhere, there are bright spots in some locations (South Korea, Indonesia), but gathering storm clouds in others (particularly India). In general terms, however, the outlook for emerging markets remains superior to that of the developed world.
Challenges clearly remain. Many market participants seem still fixated on binary outcomes and so attempt to reduce complex dynamics into a grossly over-simplified ‘risk-on’/ ‘risk-off’ formula. Against this background, we feel it is important to focus on fundamentals, namely the structural investment ideas where we have the highest conviction. There is little to be gained in our view from trying to second-guess political outcomes or indeed in seeking to call the market’s bottom. Correspondingly, our asset allocation is currently focused towards:
- Equities: Our preference remains for high quality US and globally diversified businesses with attractive growth prospects and robust balance sheets. We cannot make the case (yet) for any direct investments in European equities and also seek to avoid listed businesses with high end-market exposure to the region.
- Credit: Likewise, we continue to seek to avoid direct exposure to European (and G7 more generally) sovereign debt. We believe this constitutes return-free risk (per Jim Grant) and even German Bunds will not remain unscathed from the continent’s unfolding dynamics. We see better opportunities in emerging economies (where credit ratings are improving) and also in high yield (particularly short duration – where there is currently little evidence of defaults).
- Currency: Although the Euro has risen since last week’s EU Summit, under most circumstances, we expect it to return to a downward trajectory, most logically since a weaker Euro is better for regional growth. According to Credit Suisse, every 10% fall in the Euro adds 1% to the Continent’s GDP. The Dollar is preferred among the major currencies.
- Alternative Asset Managers: We favour investments in this area and believe that trend-followers can consistently deliver alpha over time while also improving investors’ Sharpe ratios. Fundamentals (such as a weaker Euro and/or diverging US-European growth prospects) ought to re-assert themselves,
- Gold: The case for holding the precious metal remains. Not only does it serve as an effective form of portfolio insurance, but the asset would benefit from further evidence of monetary easing, which seems increasingly likely.
Alexander Gunz, Fund Manager, Heptagon Capital
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