View From the Top

Are we able – finally – to breathe a collective sigh of relief and conclude that the near-term investment outlook will be one of improved prosperity? If global equity markets are anything to go by, then the answer to this question would appear indubitably to be ‘yes’, given January’s rise has been the strongest start to a year for almost two decades (one has to go back to 1994). Three factors appear to be driving near-term optimism, namely the impact of the European Central Bank’s Long-Term Refinancing Operation (LTRO), improved economic data from the US and easing within emerging economies. At Heptagon, we recognise the favourable impact that these factors appear to be having and have correspondingly increased somewhat our exposure to equities (especially within developing markets) and continue to have a bias towards emerging market credit over G7 government bonds.

However, we remain reluctant to endorse an unqualifiedly positive world view. Most importantly, we feel it is crucial to differentiate between perception and reality. Risks clearly do remain, particularly regarding sovereign solvency. Growth expectations may also have got ahead of themselves in the near-term despite what has been a generally disappointing earnings season to-date. These factors will require constant and careful monitoring. The danger of complaisance rather than caution is clear at present.

Certainly relative to the thesis with which we began the year, the near-term impact of the LTRO has been the biggest factor to impact sentiment, if not fundamentals. Call it ‘backdoor quantitative easing’ if you wish, but the LTRO is proving effective to the extent that it is helping to fulfil the refinancing needs of Europe’s banks, thereby reducing the negative feedback loop between sovereign risk, bank refinancing and the real economy. The depths of the European Central Bank’s (ECB’s) intentions are clear: according to its own data, it has spent €700billion on long-term refinancing operations so far, thereby expanding its balance sheet to more than €2.5trillion. To put this in context, the ECB’s balance sheet has more than doubled since the end of 2008 and is currently some €300billion larger than that of the Federal Reserve’s (€2.2trillion, $2.9trillion). A second round of ECB refinancing is scheduled for the end of February, which could see the Central Bank allocating at least a further €500billion to shoring up liquidity. A cumulative €1.2trillion that could be spent on LTRO compares to the €1.5trllion ($1.9trillion) committed by the Fed to its two rounds of quantitative easing.

If the LTRO has helped sentiment (we consider the fundamentals of Europe’s situation more sceptically below), then it is fair to concede that the outlook for the US appears to be built on more solid foundations. Two principal factors are helping. First, the key message from the Federal Reserve remains one of accommodative monetary policy, now at least through to 2014 (extended by a year), with low interest rates theoretically being more conducive to growth. Next, the recent economic data has been broadly positive with industrial production (ISM) having risen for three consecutive months, unemployment having fallen below 9% for the first time since March 2009 and last month’s housing starts up 93% from their trough. Over the longer-term, the renaissance of US manufacturing and the country’s moves towards energy self-sufficiency (BP’s latest Energy Outlook, published in January, predicts this could be the case by 2030) will be factors that should only grow in importance.

Developments in emerging economies across the world have also been encouraging and in particular we note the decisive easing undertaken by Central Banks. Brazil, for example, has decreased its interest rate by 200 basis points (from 12.5% to 10.5%) via four separate cuts over the last six months. Elsewhere, Chinese inflation appears to be abating (down from 6.3% to 4.1% over the last six months) prompting a 50 basis point cut in the Central Bank’s reserve ratio in December. Elsewhere, countries including Indonesia, Malaysia and Chile have joined the recent rate-cutting brigade. That Europe is also being supported for now by the LTRO is also positive for emerging economies given the relationship Europe’s banks have towards this region as their largest lenders.

Given these relatively positive observations, why are we not more optimistic? Beginning with Europe, however effective the LTRO may be, it still does not address three fundamental issues: (lack of) solvency, competitiveness and slow growth. The theory behind quantitative easing is that allows for an increase in lending to the private sector, thereby stimulating growth. In Europe, banks are still not lending to each other (evidenced by record amounts being placed with the ECB’s overnight deposit facility) and the LTRO seems to be mostly about helping the continent’s indebted banks delever. Moreover, with regard to solvency, let it be remembered that €650bn of European debt needs to be refinanced in 2012 (and €120bn during the first quarter in Italy alone, according to Bloomberg). A further potential issue relates to the ECB’s own balance sheet and scenarios where this may need to be recapitalised (if, for example, haircuts on Greek debt are imposed), a far from small challenge.

In the absence of greater structural reform in Europe (regarding not just potential moves towards fiscal union but also importantly labour market reform) and despite proactive policy moves in both the US and across emerging economies, the risk remains that Europe could still drag the rest of the world into recession. Both the IMF and the World Bank have cut their global growth forecasts recently, with the former now assuming 3.3% for 2012 (against 3.9% in October 2011 and 4.5% in June 2011). Europe is forecast to contract by 0.5%.

Potentially slowing global growth may also be compounded by the risk that near-term expectations may have got ahead of themselves. It is worth considering that in the US, the savings ratio (at less than 3%) has fallen to an unsustainably low level (the five-year average is 4.2%) while improvements in unemployment figures have been driven largely by growth in part-time employment (rather than a more positive shift in more structural full-time trends). Do not also forget the impact of fiscal tightening: in the US, the drag for 2012 is a mere 0.5% to GDP, but economists at Citi estimate that on a worst- case scenario, 2013 GDP could fall by 3.4% based on the implementation of all proposed tightening measures.

In the context of growth and expectations, it is also important to reiterate our oft-stated observation that corporate earnings (and outlooks) do not exist in a vacuum. For the current earnings season to-date, trends in the US have been disappointing with EPS surprises (at 1% on average) and quarterly earnings declines (running at a mean of 6%) both at their worst since the fourth-quarter of 2008 according to data from JP Morgan. The picture in Europe also appears mixed with a number of high profile corporates including Siemens, Philips and Ericsson pointing to a weaker outlook.

It is for these reasons (and without even beginning to consider larger macro risk such as rising Iranian tension) that our asset allocation stance remains broadly unchanged. Our key strategies are as follows:

• EM credit favoured: fixed income in emerging economies should benefit from looser monetary policy and lower interest rates helping to drive growth;
• High yield still attractive: we continue to believe that default risks look low given the health of corporate balance sheets and current cash levels. Short-duration looks particularly compelling;
• Although a strong case can be made for EM credit and high-yield, G7 Government Bonds look less preferable; the perceived risk-free return should now be seen as more akin to a return-free risk and it is against this background that in general, we look for fixed income managers that have the ability to take on negative duration;
• Within equities, our preference remains for the US given the near-term outlook for growth in this region. In particular, large-cap dividend payers continue to screen well. Additionally, the case for EM equities is improving, helped by the easing cycle. Here, we would prefer to gain exposure either at the defensive end of the spectrum (via businesses yielding dividends) or through companies listed in the US/UK with high emerging market exposure;
• Given the dichotomy between US and European growth prospects, the case for the Euro to weaken against the US Dollar remains. A weaker Euro would also boost regional competitiveness;
• An allocation to alternative asset managers remains logical given their diversification and lack of correlation relative to other asset classes. Of particular interest currently are strategies for gaining exposure to volatility; the logical time to consider investing is when volatility is low (the VDAX, for example, has fallen by around 15% in the last three months); and
• We continue to favour gold (and proxies–such as gold miners). The commodity should continue to outperform for as long as real interest rates remain negative and the Fed’s signalling in this respect constitutes a clear positive.

Overall, the key piece of the investment jigsaw remains Europe. With the LTRO of the ECB, ‘super Mario’ is attempting to save the day. Whether such a policy proves sustainable remains to be seen. As we wrote at the start of the year, expectations for an improved outlook have been set at a very low level for some time. In the near-term, with the perception that risk-appetite is back, they may have moved too high, too fast. Fundamentals may re-assert themselves and the core downside risks have not disappeared. While it would be fair to say that we are now somewhat less cautious, we are still far from being optimistic.

Alexander Gunz, Fund Manager, Heptagon Capital