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 descriptions of Greece‟s current financial situation as being akin to “Europe‟s Lehman moment” can lay claim for being a strong candidate as the most emotive and hyperbolic financial headline from the past month. Events in Athens (and Brussels) nonetheless serve as a reminder of global interconnectedness, with equities, bonds, commodities and hedge funds all declining during June, the first time this has happened since the February 2009 post-credit crisis nadir. However, it is worth considering not just the better-understood nature of Greece‟s problems relative to Lehman‟s, but also its context: with but 0.16% of the world‟s population, the country accounts for just 0.49% of global GDP.

From an investment perspective, if one thing seems clear then it is simply that volatility looks set to remain pronounced for some time. Even if we accept that Greece will likely need to default and/or exit from Europe‟s monetary union, we still do not know when this event will ultimately happen. The situation is also exacerbated by an absence of strong policy direction and political leadership. Significant elections in Germany, France, the US and China over the coming eighteen months also create the risk of further near-term policy stasis. Against this background, our strategy is to favour selectively corporate and high- yield short duration bonds as well as certain equities (primarily US over Europe and emerging markets). After recent underperformance, liquid onshore hedge funds also have their attractions. Meanwhile the Dollar may be a beneficiary of ongoing uncertainty issues.

For Greece, its problems can be traced back to the original structure of the European Union and its single currency project. Put simply, a monetary union was created without due consideration to political union. In other words, without a centralised form of government, the Euro suffers by an inability of its stakeholders to make decisions in a timely fashion. More fundamentally, only now that we stand at the crossroads with regard to the future of the whole project does it become apparent that there exists no formal resolution mechanism, no policy for default and no bail-out device engrained within the EU currency constitution.

Current policy orientation seems centred around denial: an insolvent country (Greek debt is forecast to rise from 143% of GDP in 2011 to 158% in 2012 according to the IMF) cannot be brought back to health simply by lending it more money. All the EU is doing is effectively buying itself time. Furthermore, no major meaningful precedents exist for a country being able to restructure its finances via austerity and privatisation alone. Existing employment structures and tax practices may also create a significant moral hazard risk.

If we accept that defeat (read: default and/or EU monetary union exit) is inevitable at some stage, then the debate moves on to its implications. Given Greece‟s size is statistically irrelevant in the context of the world economy, recession only represents a meaningful risk if Greece‟s problems prove contagious and there is a seizure within the global financial system. A swift and orderly admission of the Greek reality would certainly go some way to avoiding the latter financial scenario.

A quick tour of global macro trends highlights an inconsistency of data, particularly from recent ISM surveys in both the US and China. Importantly, a potential deterioration in trends does not equate to a situation of no GDP growth. For us, it is perhaps more indicative of a mid-cycle correction (discussed in June‟s View From The Top). Nonetheless, it remains unclear how self-sustaining the world economy is. Beyond Greek events precipitating a rise in risk aversion, the US employment situation, the growth outlook in China and global inflation trends constitute key areas to monitor closely.

Taking each in turn, with regard to employment, the recovery in America has been both joyless and jobless for many. Headline unemployment has been stuck above 9% (currently 9.2%) for more than two years and while just 5% white-collar employees lack work, within the blue-collar sector, a 22% rate is highly concerning. Even if the wage inflation gap between America and emerging economies closes over time, there remains a significant percentage of the workforce that will require re-engaging.

In terms of China, integral for the economy is how to manage its transition up the value chain. While it currently remains the engine of global growth (consuming over 50% of many of the world‟s resources, yet still accounting for less than 10% of world GDP), poor foundations supporting intellectual property rights and hence entrepreneurship may impede longer-term prospects. As importantly, in the nearer-term, policy makers in China (and much of the emerging world) will also need to contend with inflation, currently at a 34-month high. Slowing the brakes judiciously will be crucial.

Even with evidence of commodity inflation and Asian wage inflation, the good news is that for now, there are limited signs of wage inflation in the developed world. Unless the Federal Reserve (which is admittedly running out of policy ammunition and appears to lack the appetite for a third round of quantitative easing for now) and other Central Banks decide to embark on an explicit policy of seeking to inflate debt away, then this concern can be kept in check for now. A stagflation scenario would ultimately be negative for almost all asset classes.

Key for policymakers is to sustain confidence and to this end, ensuring an availability of credit is crucial. Unfortunately, Fed fund data shows the percentage of banks currently tightening their lending standards is rising. Broad money expansion is also sclerotic. A similar picture is developing in Europe with banks citing funding problems as being a major reason for restricting lending standards. Furthermore, the liquidity environment is also deteriorating in China, with both lending criteria and monetary policies becoming more hawkish.

In such an environment (also considering the relative deterioration in risk and valuation indicators), our approach is to suggest a focus towards quality across all asset classes. With regard to currencies, the Swiss Franc has been the biggest gainer in the last month, but a strong case can also be made for the US Dollar. An inevitable deflation in the global credit bubble – as well as the well-documented uncertainties over the Eurozone – should help the greenback; it remains the world‟s de facto currency and funding vehicle. EM currencies may also remain attractive, benefiting from inflationary trends, although this dynamic is increasingly well-understood.

A potentially stronger US Dollar may also help US Treasuries in the near-term, and yields have been declining recently on both the two-year and ten-year bonds. However, in general, our preference remains for (short-duration) corporate and high-yield credit over G7 debt. In broad terms (recent trends in US Treasuries notwithstanding), the yields on G7 debt do not compensate for their risks. As discussed previously, three factors – high debt/ GDP ratios, inflationary pressures and the solvency of the EU‟s periphery – imply that risks may remain weighted to the downside.

Although gold has its attractions as a fiat currency, we expect it to remain range-bound in the near-term. The asset class is highly correlated to real short-term interest rates and so upside potential may be constrained by the increasing discounting of an rising rate environment (especially in the US). It is against this background that equities look like the „least bad‟ asset class on which to focus. Even if global earnings revisions are now negative in every G20 country with the exception of Germany (according to IBES data), it should not be forgotten, that the average equity free cashflow yield currently stands at a fifty-year high relative to the corporate bond yield.

To return to volatility again, its concomitant within the equity markets is that intra-sector correlations are declining and such a market creates strong opportunities for stock-pickers. This is the approach adopted by Heptagon, but to frame some general considerations, our preference is for US relative to emerging market equities, large cap relative to small/mid-cap and, defensives relative to cyclicals. Financials appear to be an area specifically to avoid (over €40bn of Greek debt is held by European banks alone) and names such as BASF, Carlsberg EMC, IBM, Nestlé and Pepsi have strong attractions given their globally diversified and sustainable business models. Companies such as these also offer a somewhat less risky way of gaining partial exposure to emerging market growth rather than investing directly in locally listed equities.

While down from its Lehman peaks, the VIX indicator of volatility is more than 50% higher than where it stood four years ago. Near-term Greek uncertainties as well as the broader, more medium-term issues discussed above may see the VIX continuing further its upward trend. Macro news could improve towards the end of the year, especially if US corporates take advantage of favourable depreciation policies for planned capex in 2011, but even on this scenario, selective investing remains crucial. Our focus at Heptagon remains centred on best-in-class choice across both short duration high yield, corporate credit and equities. After recent underperformance – especially in the macro and CTA categories – liquid onshore hedge funds are also beginning to look increasingly attractive.

Alex Gunz, Fund Manager, Heptagon Capital