Guy Wagner: Financial markets news and analysis

The year of living dangerously

2012-01-18T11:56:25+01:00

2012 promises a rough ride for investors. Much of the industrialised world is engaged in a deleveraging process which will take several years and have negative consequences on economic growth. As a result, the global economy is extremely fragile and it won’t take much to trigger a major crisis. After 2008, the authorities tried to stabilise the situation using unprecedented fiscal and monetary stimulus measures, but in so doing, they merely delayed the outcome while aggravating the problem of excessive debt. Furthermore, the resulting massive deterioration in the public finances means that the risk of a systemic crisis is now much greater than it was 3 years ago.

The situation in the eurozone is particularly worrying. Within the eurozone, there is too much debt, too little growth, and the current-account imbalances are too excessive. This crisis is a particularly dangerous mix between a banking crisis and a public debt crisis with an undercapitalised banking system holding a large part of its assets in government bonds of overly indebted countries. This latter point also means that the European banks’ recapitalisation requirements cannot be known until the eurozone government bond market stabilises. And until these requirements are known, there will be no return to confidence in the European banks. With massive refinancing requirements, the banks will try to trim their balance sheets by shedding assets and reducing lending. This will be an additional brake on economic growth, already hampered in many countries by fiscal austerity. In short, the global economic situation is in danger of almost grinding to a halt just when the authorities have essentially exhausted their monetary and fiscal resources.

In the face of this distinctly worrying prospect, investors are entitled to want better remuneration for buying financial assets. But the opposite is happening. In recent years, the monetary authorities have done their utmost to avoid the necessary structural adjustments while at the same time maintaining artificially low interest rates. They have thus promoted a tide of speculation to the detriment of saving and productive investment. With a near-zero return on money market investments, with quality (or at least perceived as such for now) government bonds in some cases offering negative yields on short-term placements and below 2% on long-term maturities, and investment grade corporates scarcely better, the possibilities open to investors seeking regular income and trying to avoid huge fluctuations in the value of their portfolio are not very appealing.

So what’s the position for the stock markets? Although most equity markets fell in 2011, it would be unwise to think that the risks outlined above have already been factored into share prices. Especially as the US market, which generally sets the tone for the other markets, did not see a correction in 2011; based on normalised profits, it is still richly valued. The cycle of rising margins is coming to an end, and with it, that of regular better-than-expected profits. With the appreciation of the dollar, the S&P 500 also looks to be losing a vital support mechanism given that foreign sales account for nearly half of total sales of companies in this index.

By comparison, the European markets appear rather more attractive. However, this idea needs to be put into perspective. The view of Europe as cheap is based on the composition of the European indices, which are heavily weighted in favour of cyclical and financial stocks. But in the current eurozone crisis context, it is impossible to value the banks. And at the same time, shareholders in some of the banks could be sharply diluted in the event of a major recapitalisation, or complete losers in the event of nationalisation. For their part, cyclical stocks are obviously heavily exposed to any deterioration in the global situation. The cyclical nature of their results also means that they will always trade at a discount against more defensive stocks, yet these more defensive stocks are no cheaper in Europe than in the United States.

The period of convergence between European market valuations also seems to be over. Since the introduction of the single currency, the price/earnings gap between the most expensive and the cheapest markets in the eurozone has halved. With the structural weaknesses of the single currency becoming evident in the current crisis, there will continue to be high interest rate differentials between eurozone countries and this will have consequences on the economic performance of the member countries and the valuation of their stock markets. This does not augur well for the markets of Southern Europe.

As far as stock market valuations are concerned, it is worth noting that although it is obviously useful to compare current valuations to historic averages, it is also important to have an idea of the framework in which we will be evolving. Financial history shows that while US equities have traded on average at 15x profits over the last 100 years, this figure is only an average between long periods when their valuation was considerably below this figure and long periods when the valuation was a lot higher.

At the end of the last bull market in 2000, valuations were historically high. Since then, they have been on a downward trend. This trend is likely to continue given that:

- unlike the last 30 years in which increasing debt stimulated economic activity, the deleveraging process will dampen it. With less potential for profit growth, investors will pay less for these profits;

- in the coming years, we are likely to see shorter economic cycles and more frequent recessions. Corporate profits will be more volatile. Financial history shows that there is a negative correlation between earnings volatility and the valuation multiples accorded to these earnings;

- the increase in multiples during the 1980s and 1990s was mainly due to the fall in interest rates as inflation receded. Interest rates are currently at very low levels. Rather than reflecting a particularly brilliant economic environment, this is due to a host of structural problems. If interest rates fall further, it will be because Europe and the United States have entered a Japanese-style scenario, but with considerably less social cohesion. The experience of the Japanese market in the last 20 years shows that there has been a positive correlation between interest rates and equity valuations, the latter declining along with the former;

- in recent years, companies have been the prime beneficiaries of the fruits of economic growth. As a result, corporate profits are capturing a historically high share of national income. This trend cannot continue;

- the end of the Cold War sustained valuation multiples in the 1990s. Today we are seeing a new wave of geopolitical risk.

By contrast, the Japanese market is genuinely undervalued. Companies in the Topix index are trading on average below their book value and it is possible to find a good many companies whose stock market capitalisation is less than the net cash they hold. As is generally the case with an undervalued stock market, no-one is currently showing any interest in the Japanese market. While it is true that in the context of a slowdown in the global economy, investing in a market generally considered as cyclical is not the first thing that springs to mind, in Japan’s case, the potential for decent long-term returns (due to its low valuation) would at least compensate the investor for the risks incurred.

Price-to-book ratio on the Japanese market

The last year has confirmed that the emerging markets are not only correlated to other markets, but that their volatility is even comparable to that of the more cyclical sectors in Europe and the United States. This is hardly surprising given that exporters and commodities feature prominently in most of the emerging indices. A slowdown in the global economic situation and appreciation of the dollar will not be beneficial to these sectors. On the positive side, the easing of inflationary pressures should enable the authorities to relax their monetary policy.

In the current context, it is important for investors:

- not to allow themselves to be influenced by short-term fluctuations on the financial markets. These fluctuations are the result of the interaction between the authorities’ interventions and the poor fundamentals;

- to worry about what they hold in their portfolio, not about what they don’t hold. Concessions should not be made on the quality of the assets held, even if these assets temporarily underperform;

- to wait, if possible, for better buying opportunities to arise;

- to avoid creating a rational argument for the positions they hold that they don’t want to sell.

Based on all this, our investment recommendations for 2012 are:

buy high dividend shares of non-cyclical companies:

in the current environment, stable quality income is becoming rare and something that is rare should be in the portfolio. Demographic trends also support strategies for producing regular income. Companies paying decent regular dividends should benefit. Given the risks hanging over growth, companies whose activities are very sensitive to the global economy should be avoided;

buy assets that will be considered as safe havens in the event of a downturn in the economic and financial situation:

the past has shown that when aversion to risk increases, the US dollar benefits. Despite the many problems in the United States. the dollar continues to be the reserve currency which investors flee to when they are fearful. Especially in an environment in which the future for the dollar’s principal alternative, the euro, is uncertain to say the least.

In a context in which confidence in paper money is wearing thin, gold remains the ultimate safe haven for many investors. Its bull run seems set to continue, notwithstanding temporary corrections such as that at the end of 2011. Also, note that the central banks of emerging countries are continuing to buy gold. If the price of gold holds up or continues to increase, shares in gold-mining companies are undervalued, especially if these companies continue to demonstrate better financial discipline than in the past.

The government bonds of countries that continue to retain market confidence will also profit from structural economic weakness, despite the current very low level of long-term interest rates. The 30-year US rate could return to its end-2008 level in 2012. If this happens, the potential yield on a 30-year bond would be well over 10%. However, it is important to emphasise that the volatility of such an investment could be too great for a traditional bond investor;

take advantage of corrections to increase the weighting of assets with good medium and long-term prospects:

It is sometimes helpful to bear in mind that the major trend marking the 21st century economy is that the East will steadily overtake the West as the driver of the global economy. In general, emerging countries have better economic fundamentals and more favourable growth prospects. Their stock markets should therefore occupy an increasing portion of a diversified portfolio. Since the stock markets of these countries are generally ‘high beta’, meaning that in the short term they tend to amplify the movements of industrialised markets – up or down – attractive purchasing opportunities could arise during the year.

US, European and emerging markets over the last 10 years (in euros)

Note that fears of a pronounced economic slowdown could also temporarily weigh on the currencies of some countries even though their fundamentals are better. Apart from emerging currencies, the Australian and Canadian dollars and Norwegian krone are often considered cyclical. Corrections in these currencies would constitute buying opportunities for the longer term;

buy shares of multinational companies active in defensive sectors:

the financial situation of these companies is generally excellent and in an environment in which government public finances are deteriorating, their shares could replace many countries’ sovereign bonds as preferred assets in the portfolios of institutional investors. Note that these companies often pay attractive dividends and realise a growing proportion of their earnings in emerging countries;

avoid heavily indebted companies and countries:

high debt is an enormous problem in an environment marked by low growth and deflationary trends. Furthermore, in the current year, governments and banks have massive refinancing requirements. Non-financial companies are in danger of losing out in such an environment;

avoid very cyclical assets;

avoid banking stocks.

Finally, long/short strategies aiming to buy quality assets while hedging part of the market risk make a lot of sense in the current environment.

BL-Global Flexible - Situation as at 12 January 2012

2012-01-18T11:56:06+01:00

Asset Allocation

The net equity allocation of BL-Global Flexible as at 12 January is 47%. 95% of the fund's assets are invested in equities, with 50% of the equity exposure hedged through the sale of futures on equity indices.

In geographical terms, the fund is invested 41% in Europe (20,5% after hedging), 30,5% in North America (3%), 18% in the Pacific Basin and 5,5% in other countries.

Equity asset allocation

* Hedging

As a broad general rule, equity investments currently tend to be in defensive, non-cyclical sectors with a particular emphasis on dividends. At the end of December, the equity portfolio's average price/earnings ratio was 14,6, and the average dividend yield was around 3,5 % (gross).

Currency allocation :

The currency allocation differs from the asset allocation. We use forward sales to lower the exchange rate risk on certain currencies or to increase exposure to other currencies. The following graphs show the currency allocation before and after forward sales.

Currency allocation before forward sales

Currency allocation after forward sales

Performance

The net asset value of BL-Global Flexible has fallen by 1,17 % in 2011. Since the start of the year, it has risen by 2,3 %.

Endgame for the eurozone?

2011-11-10T12:05:31+01:00

'Snowballs get bigger as they run downhill.'

What with the EU summit of 26 October, the announcement and then the abandonment of the Greek referendum, and last Friday’s G20 summit, the last two weeks have certainly been turbulent for the eurozone. At the end of the fortnight, it's increasingly evident that the authorities are unable to find a solution to the crisis.

The 26 October summit, frequently referred to as the 'last chance' (and the 14th in 21 months), resulted in 3 decisions:

- ‘optimisation’ of the European Financial Stability Facility (EFSF) through leverage;

- a voluntary 50% ‘haircut’ on Greek debt;

- a bank recapitalisation of 106 billion euros between now and the end of June 2012 to arrive at a capital ratio of 9% for the banks.

These decisions triggered a mighty rebound on the stock markets on 27 October. But the response of the bond markets was distinctly more lucid: after briefly easing, the 10-year Italian bond yield rapidly started to climb again and has since definitively passed the 6% mark. The spread between French and German bonds has continued to widen and now stands at a 20-year record.

10- year interest rate spread between France and Germany

A plan without details

The bond markets soon saw that what was sold as a plan for a solution in fact boiled down to a few grand declarations followed by a stark lack of detail. A number of questions surround each of the three decisions taken:

1. the voluntary haircut on Greek debt:

- which creditors will have to accept the 50% write-off? Greek debt currently amounts to around EUR 350 billion. 150 billion are held by the ‘Troika’ (the European Central Bank, the International Monetary Fund and the European Commission) and won’t be affected by the discount. Thus the European Commission no longer represents 50%, only 30%. Of the remaining 200 billion, around 85 billion are held by banks and Greek pension funds and it is highly likely that the latter will do their utmost to avoid the write-off. If so, the actual discount would be 16%;

- the nuts and bolts of the write-off that the banks are required to ‘voluntarily’ support have yet to be negotiated. And there is no certainty that all the banks concerned will actually participate in the plan;

- what’s to stop other countries demanding a trim of their debt too?

Finally, the decision to make this discount a ‘voluntary’ event to avoid it being a ‘credit event’, which would trigger the payment of CDS (Credit Default Swaps), is likely to prove counterproductive. Why would an investor go on buying default insurance if it is obvious that it has no sound legal basis? And if the insurance isn’t valid, why buy the debt of peripheral countries?

2. recapitalisation of the banks:

- why does the European Bank Authority set the capital requirements at only 106.4 billion (we must at least applaud them for the detailed figure) whereas the International Monetary Fund’s estimate is double that amount?

- on what assumptions has the EBA based this figure? And what about a potential partial default on the debt of other countries in the eurozone?

- what if the banks decided to increase their equity ratio by decreasing their assets rather than by recapitalising (selling government bonds for example)?

- what will be the impact on the banks’ willingness to lend (and therefore on economic growth... and therefore on the quality of private and public debt... and therefore on the banks’ equity... etc. etc.)?

- what benefit would there be to private investors in recapitalising banks which have been more or less prohibited from paying dividends? If there is a lack of interest from private investors, the necessary capital will have to come from governments, generating a new round of public debt increases with consequences on their rating and their capacity to service their debt.

It is important to note that a credible recapitalisation of the banks is an indispensible condition for a return to confidence in them. And a return to confidence is all the more necessary given that the European banks will have to refinance some 600 billion euros of debt maturing in the next 12 months.

3. optimisation of the EFSF resources:

- first, it is ironic to note that the solution to a crisis provoked among other things by excess leverage is supposed to come from introducing significant leverage into the EFSF. A problem caused by too much debt won’t be resolved by adding even more debt;

- one of the possibilities envisaged seems to be for the EFSF to guarantee the first 20% of the loss in the event of payment default by a member of the eurozone, with this guarantee only being valid for newly issued debt. In practice, it’s not very clear how this is supposed to operate. In the first place, it is odd to offer this type of guarantee to an investor for government bonds issued by developed countries, given that this kind of debt is supposed to be of the ‘highest quality’ and therefore risk-free. In explicitly recognising that this is no longer the case, the European authorities are turning bonds into risk assets, thereby increasing the cost of financing of the countries concerned on a long-term basis. Increasing the EFSF’s resources through leverage won’t reduce the risk of default; it will just cause a change at the level of the losers – private lenders or tax payers. Secondly, history shows that when a country defaults, the loss incurred by its creditors is rarely limited to 20%. And thirdly, if the guarantee only covers newly issued bonds, this solution will create a two-tier market with new bonds and old bonds at separate levels;

- the idea of linking the EFSF to a special fund in which private investors and non-member countries of the eurozone could participate is also peculiar. Why would these lenders want to put money into such a fund if (for example) Germany is not prepared to contribute more money to the EFSF? Not to mention the fact that the idea of asking for help for the eurozone from countries like China and India, which despite the size of their currency reserves are still relatively poor, is frankly embarrassing.

- Ultimately, the EFSF represents an empty box filled with promises of a money given by countries that may well have to borrow that same money. Regarding the potential size of this empty container, the Financial Times summarised the situation very neatly in its edition on 28 October, noting that the fund’s size is ‘an estimate based on the still-untested ability to multiply a still-unknown asset base by four to five times’.

A crisis of confidence

Having started off by indicating that the idea of a partial default of Greece was absurd, then that Greece’s problems were not going to knock-on to other eurozone countries, then that the European banks were adequately capitalised, the European authorities finally proposed a plan which does nothing to reinforce investor confidence in the debt of peripheral countries or in European banks. Two crucial objectives have not been reached. Contagion to other countries in the periphery, and even from South to North, has not been stopped and confidence in the banks has not been restored. As for Greece, the plan will condemn it to years of austerity and high unemployment with the sole promise of eventually reducing its public debt to 120% of its GDP, which is double the 60% figure used for Maastricht.

A fiscal union?

It is obviously easy to criticise. But the fact is that the eurozone problems are so numerous and complex (high public debt, interdependence between state and banks, under-capitalisation of the banks, lack of competitiveness in the South, etc.) that it’s hard to find a solution. These problems are mainly due to the fact that, economically, monetary union between countries as different as Germany and Greece never made any sense and that the type of economic environment that enabled this union to function for a few years in spite of everything, is no longer there and isn’t about to return anytime soon. The absence of fiscal union has done nothing to improve the situation. Such a fiscal union does not seem to be about to happen. On the one hand, the public finances in Germany are not particularly brilliant, especially when future expenditure based on an ageing population is taken into account. On the other hand, the euro is almost a relic of the cold war. Today, the economic and geopolitical links between the eurozone countries are weakening. There was greater integration between the eurozone countries in the three decades before the advent of the single currency. It is hard to imagine Germany sharing its sovereignty on taxation (which fiscal union would require) with countries whose interests are not necessarily the same. And even if it did, the conditions that it would impose in return would be likely to make these countries run away.

Germany's dominant position

If, for now, Germany seems to be prepared to work for the survival of the eurozone in its current form, it’s because the weakness of other countries allows it to impose its views. Greater participation by banks in Greece’s default, the refusal to transform the EFSF into a bank, increased budgetary surveillance of countries in difficulty and the refusal to accept a more significant role for the European Central Bank in financing governments are all points on which Germany’s wishes have prevailed over other countries, especially France. It should also be noted that since the beginning of 2010, the German 10-year bond yield has declined from 3.4% to 1.8%. The crisis has therefore enabled Germany (and Northern Europe in general) to significantly reduce its cost of financing while this cost has soared in Southern Europe. This will only exacerbate the competitive differential between North and South.

Numerous observers have criticised Germany’s position on a greater role for the ECB in financing the periphery countries. It is true that in enabling the central bank to print money to lend to the periphery countries or to the EFSF, it would be possible to temporarily resolve the current crisis and delay its endgame. Countries in difficulty would then hardly have good reason to sort out their public finances though. History also shows that the easy solution of printing money has very undesirable consequences in the medium and longer term with inefficient capital allocation and rampant inflation. The fact that Germany is opposed to such a solution should therefore be applauded. But in a context where the rules of the free market economy are being increasingly suspended by the authorities, there is no certainty that the German government won't give way in its turn. (It is also ironic that some people consider that the market economy is responsible for the current crisis when, in fact, it is the failure to abide by the rules of such an economy that is the cause: artificially low interest rates for several years, protection of the banks against the consequences of their actions, capital directed to activities that do not create real added value, refusal to allow the disappearance of non-profitable companies, monetary union defying economic laws etc.).

Although the German position therefore seems to reinforce Article 123 of the Treaty of Lisbon, barring the European Central Bank from buying up the debt of Member States, it also substantially reduces the possibility of the eurozone’s survival in its current form. The solution recommended by Germany of budgetary discipline and general austerity will not be able to function either. It would plunge the peripheral countries into a vicious circle, with dangerous social and political consequences.

In my article on 6 July, I wrote that the eurozone crisis also poses the question of Europe’s governance. Until now, the creed of the European authorities had been to say that, whatever the cost, the single currency must be defended in its current form. This position seems to have moved on during the past week with the announcements by Angela Merkel and Nicolas Sarkozy that Greece was free to leave the euro. In this respect, the idea of a referendum mooted by the Greek Prime Minister was far from absurd. Asking the Greek people if they would prefer to submit to years of austerity or suffer the consequences of leaving the euro should form part of the democratic process after all. However, since decisions concerning the European process have only rarely been taken democratically, the general uproar that greeted the announcement of the referendum was hardly surprising.

A lack of growth

To sum up, Europe has numerous problems, starting with the debt overhang. To reduce excessive debt (in relation to GDP), the most agreeable solution is economic growth. However, this solution does not look realistic at the present time, given that the money spent in recent years wasn’t spent to increase the medium and long-term growth potential of the eurozone. On the contrary, the lack of growth (reinforced by budgetary austerity) risks further aggravating the problem. Three possibilities remain:

- transfer the debt from highly indebted countries to less indebted countries through some kind of fiscal union;

- inflation to reduce the real cost of the debt;

- write down the debt.

Because of its history, Germany has a very strong anti-inflationary bias, unlike the Southern countries. Since it is in a position of strength to impose its view of things, the first two solutions are therefore off the table. Regarding the third solution, the German position is that a default on government debt should first impact private creditors, then the countries affected, and only then the eurozone as a whole. For a country to obtain partial default on its debt, it will have to submit to control by its European partners or the International Monetary Fund, with these somehow taking over the day-to-day management of the country. This is likely to enrage the population of the country in question which would take a very grim view of being supervised. But on the other hand, not imposing strict controls would mean rewarding the country for its poor management and would not encourage it to engage in structural reform. It’s a vicious circle.

Seeking people to blame for the current situation is a pointless exercise! Germany may reproach the Southern countries for their lack of discipline, while in their turn they will retort that it’s this very lack of discipline that is at the origin of the German surpluses by creating demand for German products. Rather than wanting to obtain even more powers to try and settle the crisis and thus strengthen anti-European sentiment among their people, the European leaders need to recognise their responsibility in the current problems and reflect on how to reduce monetary union to something that is viable for the long term. This will mean recognising that in its current form it isn’t!

BL-Global Flexible: Investment in gold mining shares

2011-09-20T13:41:54+02:00

We have invested 2% of the assets of BL-Global Flexible in gold mining companies, with an objective of gradually raising this to 5%.

I’ve written on many occasions that buying gold is speculation not investment. This statement is due to the fact that gold has no intrinsic value and cannot be valued whereas the intrinsic value of a share can be assessed based on the underlying company’s assets, shareholders’ equity, current and future profits, current and future dividends etc.

So why invest in gold mines? After all, if it’s impossible to value the product they sell, it follows that it must also be impossible to value the companies.

First, speculation can be a good idea, provided you are aware that you are speculating. Two conditions are necessary for the price of gold to rise:

a scary economic and financial environment which causes investors to seek a safe haven and
the conviction among investors that gold represents such a safe haven

The first condition seems undoubtedly to be met while at the present time there is no sign that the second is not.

So, if we start from the hypothesis that the price of gold is likely to at least remain at its current level (~1,800 $/ounce), an investment in gold mines could be considered a form of rational speculation. While gold mining share prices generally exaggerate movements in the price of gold (up or down), this time they have lagged behind. This can be seen in the following graph, where the gold miners index is divided by the price of gold. A drop in the ratio means that the miners have underperformed the metal, and a rise that they have outperformed.

There are a number of potential reasons for the miners’ underperformance against the actual metal:

doubts concerning the sustainability of the rise in the price of gold
increase in production costs especially due to higher energy prices and wages
the fact that in recent years the rise in the price of gold has not been reflected in the results of a number of gold mining companies
concerns over the use of surplus cash flow (in the past, mining companies have not always been very disciplined in this respect)
the increase in capital spending announced by a number of companies and uncertainties over the return on these investments
the emergence of paper securities (index tracker funds) aimed at replicating the performance of the price of gold.

The valuation of gold mining companies has consequently decreased considerably in recent years. According to various experts, the share prices of these companies currently discount a price of gold of around 1,300 $/ounce. Based on the current price, this would give our rational speculator a security margin of some 25%.

In addition, the stock market performance of gold companies since mid-August has been encouraging. Since then, they have decorrelated from the stock market, finally following the price of gold more closely.

In terms of individual stocks, there is generally a distinction between established producers (Tier 1), intermediate producers (Tier 2) and junior producers (Tier 3). In terms of investment, the latter are obviously by far the most risky. The Market Vectors Junior Gold Miners tracker fund represents a way of holding a diversified investment in this segment.

For their part, established or intermediate producers can be differentiated on the basis of their production costs, current and future reserves, and valuation. We have purchased Goldcorp, Gold Fields, African Barrick Gold and Newmont Mining. The latter has a unique dividend policy, directly related to the price of gold. Note that there is also a tracker fund for the 30 biggest gold mining companies: Market Vectors Gold Miners.

Should we still be buying equities?

2011-09-16T16:43:38+02:00

The last few weeks have been miserable for equity investors – the Euro Stoxx 50 index, for example, has slumped by 30% since 1st July. Whereas at the start of 2011, equity indices seemed set to return to their pre-2008/2009 crisis level, now some are even in danger of dropping below the levels seen at the very depths of the crisis.

Added to the recent slide in share prices is the fact that the longer term performance of the markets is hardly more joyful. At the turn of the century, the German DAX was hovering around the 7,000 mark. Some 12 years later, the index stands at 5,100. In France, the CAC 40 is a full 50% below its end-of-1999 level. In the United States, the S&P500, which has held up considerably better than the European indices this summer, is still trailing by 20%. Even people who were prepared to accept that an investment in equities needed a horizon of several years are starting to find that time is indeed long and reflecting on John Maynard Keynes’ quote that in the long run we are all dead. So should we still be investing in equities?

Before answering that question, it is worth reminding ourselves what a share represents. There are two ways for a company to finance itself – by borrowing or by issuing shares. The issue of shares represents equity, while borrowing (debt securities) represents external capital. Shares are fundamentally different from debt securities in that they represent a stake in the company. Shareholders are co-owners of the company and the return on their investment depends on the company’s future results. Holders of a debt security (generally a bond) issued by that same company are merely simple creditors and only concerned by the future progress of the company insofar as it affects the company’s capacity to pay the annual interest and repay the principal at maturity.

Accordingly, anyone contemplating buying shares in a company should be asking the same questions as someone considering acquiring the entire company. Such questions will inevitably revolve around two issues: quality and valuation.

In terms of quality, does the company in question have attributes that differentiate it from the competition and enable it to achieve higher margins and generate greater profitability?
In terms of valuation, can the company be bought at a reasonable price, in other words at a sufficiently low price (in relation to its capital, assets, current and future profits etc.) in order for the investor to be able to expect a sufficiently high return given the risks incurred?

For listed companies, there is also a psychological component to be factored in. Share prices go up and down, often bearing no relation to what is actually happening at the company. (I am always astonished to note that some 10 million Coca-Cola shares are traded every day when, in the majority of cases, there is no major news involving the company. Why did investors who didn’t want to buy/sell Coca-Cola on Tuesday suddenly want to do so on Wednesday? I still haven’t found an answer to that one...) Investors purchasing a stake in a private company don’t have this problem. They need only concern themselves with the operational side of the company and are not faced with a market telling them – in the form of a rise or fall in the share price – whether they were right or wrong.

Daily fluctuations in share prices may frighten investors but they can also offer opportunities. Benjamin Graham illustrated this using a character he called ‘Mr Market’, who Warren Buffett often mentions to his shareholders. The story goes like this: imagine that you and Mr Market are partners in a private company. Mr Market comes to see you every day and gives you a price at which he is prepared to buy your share in the company, or sell you his. The company’s results are relatively stable but the price that Mr Market offers you swings to extremes. The reason for this is that Mr Market is emotionally unstable. Some days he is wildly optimistic and can only see the positives. On those days, he tends to offer you a very high price. On other days, he is depressed and pessimistic and can only see a future clouded with problems. So the price he offers you then is very low. Mr Market also has another interesting personality trait: he perseveres and doesn’t mind if you reject his offer – he’s always back the next day. Whether a transaction takes place is your call. It is therefore extremely important not to let yourself be influenced by Mr Market's mood and not to fall under his spell. You are only interested in his wallet, not his views.

The story of Mr Market may seem rather quaint in the modern world where investment is often presented as something complicated and mysterious, with stupid theories about efficient markets, and where computer programs often take precedence over good judgement in decision-making. But the truth is that nothing has changed: buying quality assets at a reasonable price remains the best recipe for a successful investment over the long term.

However, there is another very important lesson in the Mr Market allegory. You can only take advantage of his mood swings if you are better at valuing your company than he is. I am often surprised by the number of people who buy shares in a company without the least idea of what the company is worth. But you can’t take advantage of a particularly low or high share price unless you have a benchmark to establish that the price IS very low or very high. At BLI - Banque de Luxembourg Investments, we call this benchmark the company’s intrinsic value. Without such a benchmark, you are totally exposed to market uncertainties, with the risk of you yourself becoming Mr Market.

It might seem obvious that people would want to buy quality companies at reasonable prices. But it’s not quite so simple in practice. The dot.com bubble at the end of the 1990s is one of the best illustrations of this. Newly created companies not making any profits (even in some cases not generating any revenues) suddenly had enormous stock market capitalisations while other companies were completely side-lined despite posting solid results. For a manager, this poses a very real problem: yielding to a trend under market (and often client) pressure or persevering with a strategy that makes good sense, with the risk of losing a lot of clients who reproach you for ‘being out of touch with the market’? At BLI, we have also adopted another Warren Buffett saying: ‘You don’t need to be more intelligent than other people, you just need to be more disciplined.’ In the end, you get the clients you deserve.

So to get back to the original question, ‘should we still be buying equities?’, the first consideration is that the question is too vague. After all, nobody would think of asking whether we should still own companies. Yet, as indicated above, buying a share in a company means becoming a co-owner of that company. (But note that this is only true in countries where the rights of shareholders and, particularly, minority shareholders, are protected.) Despite the risk of recession or the European crisis, you see very few entrepreneurs ditching their companies, and certainly considerably fewer than investors offloading their shares (remembering of course that for every seller there is a buyer). Moreover, unless you are obsessed with stock market indices, buying ‘equities’ or ‘the market’ doesn’t mean anything. It would be better to rephrase the question as follows: ‘At current share prices, is it possible to find quality companies with a sufficiently low valuation as to offer a reasonable prospect of an attractive return over the medium to long term?’ The ‘medium to long term’ part of the question is significant. ‘Buying quality companies at reasonable share prices’ is not a formula to gain lots of money quickly. Numerous studies have shown that over the short term (less than a year), there is no correlation between valuation and return. A quality company purchased at a low price could become even less expensive in the short term, which generally means a fall in its share price.

The answer to the rephrased question is yes.

Economic and financial environment: some key points

2011-09-07T15:31:20+02:00

"Tough decision-making is never easy, and wishful thinking and trying to postpone the day of reckoning is always tempting."
(Jeremy Grantham: Children at play, August 2011)

Too much debt

- the era of recourse to credit and debt to finance increasingly artificial growth seems to have ended. A large part of the global economy is currently facing a situation of excessive debt. The necessary deleveraging will hamper economic growth, making it even more difficult to service the debt. A vicious circle is thus in danger of setting in;

- from an economic viewpoint, the stimulus measures taken by the authorities in recent years were poorly designed. They are doing nothing to enhance the growth potential of their economies and have only added high public to high private debt;

- the problem with high public debt is that the interest paid on the debt absorbs an ever-larger part of the resources that could otherwise be used to create jobs and increase the standard of living;

- the current situation is more critical than that of three years ago given that interest rates are lower and that the degree of government debt is higher than in 2008. The authorities have very few resources to deal with the crisis;

- the current crisis is aggravated by a severe lack of leadership on both sides of the Atlantic;

Europe: No solution in sight

- in Europe, the economic and financial problems have been amplified by the fact that the eurozone is not fulfilling the necessary criteria for a single currency: there is very limited coordination between the economic policies of the member states, labor mobility is weak, and fiscal transfers not existent;

- since the introduction of the euro, the economic fundamentals of the eurozone have never been so divergent;

- quite simply, there is no realistic scenario in which certain European countries could avoid restructuring their debt. The measures taken to remedy the problems in the peripheral countries are doing nothing to kick-start growth in these countries. To the contrary in fact, since the fiscal austerity that has been imposed will reduce economic activity even more, leading to further deterioration in the public finances – as we saw last Friday with the Greek government’s announcement that the objectives of reducing the public deficit to 7.4% in 2011 could not be sustained due to a bigger-than-expected contraction in Gross Domestic Product;

- in the event of restructuring the government debt of some countries, the majority of listed European banks would be in danger of facing a problem of solvency. This puts the stock price falls of the financials into some sort of perspective;

EURO STOXX banks index

- in a recent paper entitled ‘Budget Cuts and Social Unrest in Europe, 1919 - 2009', the CEPR noted that there is a positive correlation between budgetary austerity and social instability. Demographic trends will result in social programmes becoming an unsustainable burden on young people;

What future for the euro?

- it will be difficult to solve the problem of competitiveness of certain countries in the eurozone without adjusting their currency. And without such an adjustment, these countries will only be able to become competitive again by reducing salaries and opening up their labour market at a time when unemployment rates (especially among young people) are already very high;

- the idea that the euro has more disadvantages than advantages is currently gaining ground in some countries. At the same time, the current political class continues to stick to the notion that more European integration is always better. This is creating a rift between the leaders and the people.

BL-Global Flexible's investment strategy in this environment

BL-Global Flexible 1 September 2011

2011-09-07T15:31:04+02:00

Equities

Based on normalised profits, equity valuations are not particularly attractive.

In the longer term, an environment characterised (among other things) by:

weak growth in industrialised countries and a risk of more frequent recessions,

increasing intervention in the economy by governments to ‘solve problems’,

growing tensions between countries with a risk of protectionism,

growing social tensions,

a potential risk of high inflation in some countries,

a risk of payment default in other countries

a risk of a eurozone breakup,

does not point towards higher multiples. Quite the opposite.

Our strategy

Buy high quality companies (with low gearing, a competitive advantage, and high profitability) and reduce market risk by selling equity index futures
Maintain a bias in favour of ‘emerging’ markets (South-East Asia and Brazil)
Focus on dividends.

Asset allocation

* Hedging

Bonds

In a high-debt/low-growth environment, the risk of deflation is greater than the risk of inflation. This is beneficial to high-quality government bonds. The problem lies in the fact that high-quality bonds are becoming scarcer in industrialised countries and that those currently seen as such (e.g. Germany and the United States) are offering very low yields.

The often-better fundamentals of emerging markets are an argument in favour of their sovereign debt but the interest rate differential between emerging and industrialised countries has already narrowed considerably.

Our strategy

Generally avoid currency risk on the bond portfolio
Restrict euro-based portfolios to North Europe sovereign debt
Actively manage the weighting and duration of the bond segment according to long-term interest rate trends: with an increase in March/April 2011 after the sharp upturn in bond yields between October 2010 and April 2011, and a decrease at the moment after the sharp downturn since May
Invest opportunistically in the sovereign debt of certain emerging markets (in euros/dollars but mainly in local currency)

10-year German bond yield and bond allocation of BL-Global Flexible

Currencies

In an environment of weak growth and a risk of deflation, no government wants a strong currency. Some countries can more easily encourage a depreciation of their currency than others.

Neither of the two main currencies, the euro or the dollar, currently inspires great confidence. Periods when risk aversion has increased have been favourable to the dollar in the past, but the jury is still out on whether, after two rounds of QE and the prospect of a third, the US currency can still be considered as a safe haven.

At the present time, it is impossible to predict the consequences of the European crisis on the euro: a breakup?, a stronger euro (exit of Greece, Portugal, ...)?, a weaker euro (ECB loss of credibility, Germany to exit, …)?

The authorities of countries considered for the time being as a safe haven (Switzerland, Japan) are actively acting against any appreciation of their currency.

The fundamental trends argue in favor of an appreciation of Asian currencies in the long term.

Currencies connected to commodities are attractive, especially if they are from countries with solid fundamentals.

The interest rate differential between the principal currencies in industrialised countries is disappearing as interest rates home in on zero pretty much everywhere..

Our strategy

Consider currency allocation as separate from asset allocation using forward sales to increase/decrease exposure to certain currencies
Maintain significant exposure to the portfolio’s base currency to limit volatility
Prefer currencies of countries with solid fundamentals (a budgetary surplus, current account surplus, low public debt): especially SGD, CAD, NOK and SEK.

Currency allocation before hedging

Currency allocation after hedging

The above strategy has helped BL-Global Flexible to hold up well during the markets' decline in July and August, despite its net equity allocation of 45%.

Do the recent stock market declines represent a buying opportunity?

2011-08-18T17:14:53+02:00

“If we mean to prosper long term, I am sure that we need to act to make debt less attractive to everybody: it really is a snare and a delusion.”
(Jeremy Grantham: Children at play, August 2011)

“A novice monk approaches his teacher and asks, “Is this a bull market or a bear market? ” The teacher replies, “If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?”
(John Hussman: Zen Lessons in Market Analysis, October 2009)

In the space of just two weeks, most markets have lost some 15%

Equity markets have seen something of a nosedive since the end of July. In the space of just two weeks, the markets shed 15%, and in some cases even more.

This fall can be explained by factors that are cyclical as well as structural.

Key issues on the cyclical side are the deterioration of economic statistics , especially in the United States, and company results coming in below expectations.
On the structural side, there is the public finances problem with the crisis in the eurozone and the distressing spectacle of the raising of the debt ceiling in the United States, followed by a cut in the country’s rating.

But perhaps the tumble on the equity markets represents a good buying opportunity?

Source: S&P, Shiller, BLS, Global Financial Data, Morgan Stanley Research
Note : Shiller PE defined as inflation adjusted price to 10Y average EPS

From private to public sector debt

In recent weeks, investors have generally become aware of the fact that the economies of the majority of industrialised countries are fundamentally weak and that the rally of the last two years was largely artificial and is therefore still fragile. But it is no real surprise that these economies are weak: even 80 years ago, the economist Irving Fisher noted that the major economic problems stemmed primarily from excessive debt. Just as debt can (temporarily) stimulate growth, cutting debt hampers it since the money needed to reimburse debt is no longer available for consumption or investment. Furthermore, the actions of the fiscal and monetary authorities over the last three years have done nothing to improve the situation – on the contrary, they have aggravated it. What was initially a problem of excess debt in the private sector has become a problem of excessive debt in the public sector. The result is that the authorities no longer have the means at their disposal to stimulate economic activity. In fact, quite the opposite in most countries where budgetary austerity is the name of the game – austerity that will constitute an additional brake on growth. This makes a return to recession quite possible.

On the structural side, the problems associated with the deterioration of the public finances are still far from solved. Particularly in Europe, the situation is becoming increasingly worrying. The cut in the United States rating could end up causing more problems in the eurozone than in the United States. How can France’s AAA rating be justified when the United States has had that top status taken away? Yet if France were to lose this rating, the very mechanism on which the support for the peripheral countries is based (giving such countries access to capital at a reasonable financing cost via a vehicle like the EFSF which has an AAA rating) would be fundamentally called into question. Furthermore, the increase in the price of CDS (credit default swaps that act as an insurance policy against payment default) on Germany show that investors are even starting to wonder about countries hitherto considered as ‘beyond doubt’, as the measures taken to combat a problem of excess debt in the peripheral countries is in danger of generating a problem of excess debt in the ‘hard core’ of the eurozone.

The economic environment does not look set to improve anytime soon. But is the bad news already discounted in share prices? After all, there are many commentators claiming that equities are particularly cheap at the moment.

Are equities cheap?

Where then are we in terms of valuation? To answer that, we tend to apply Shiller’s price/earnings ratio. As has been explained many times, this ratio has the advantage of using average earnings over the last 10 years as its denominator and therefore avoids being based on one exceptionally good year (producing a very attractive P/E) or one bad year (giving a very high P/E). The Shiller ratio is all the more justified in the current situation where corporate margins – at exceptionally high levels – are starting to come under pressure. On the basis of this ratio, the following conclusions can be drawn:

The US market is currently trading at a Shiller P/E of around 20. The long-term average for this ratio is 16. Using that average of 16 would put the S&P 500 index at around 950, compared to its current level of 1,190. Note that in recessions, this ratio has fallen to 13.6 on average;

The European market is trading at a Shiller PE of 11.5. This figure is slightly below its long-term average but is still considerably higher than the level reached in bear markets of the past. At the lowest point in the 2008/2009 bear market, this ratio fell to 9.7.

So generally, we could say that the US market is currently relatively expensive while the valuation of the European market seems a good deal more attractive. But this assessment should be put into perspective given the significant weight of financials in the European indices. Admittedly, financial stocks do appear to be very cheap at the moment but their shareholders run the risk of being heavily diluted by future recapitalisations.

The theme of valuations calls for two additional remarks. First, it is clear that all valuation models based on interest rates show that equities are exceptionally undervalued. However, the Japanese example shows that using this model in an environment of high debt, weak growth and a risk of deflation makes no sense. Second, while it is interesting to compare the valuation of equities to the long-term average, the fact is that equities very rarely actually trade at this average. The average is useful to see whether, compared to the past, equities are rather expensive or rather cheap but it is just as important to find out if we are in an environment suggesting an increase or a decrease in equity valuations. The current environment would suggest a rise in the equity risk premium and thus a contraction of the multiples.

The equity markets’ recent correction does therefore not constitute a buying opportunity. While it is true that the dip in prices reflects a reassessment of the economic prospects by investors, it is nevertheless the case that the conditions for a sustainable recovery in stock prices are not in place: the economic and financial environment does not appear to be on the point of improving and equities are not cheap enough.

How to invest?

In such an environment, our investment strategy is based on the following three principles:

in terms of currency, we prefer currencies of countries with solid fundamentals (budgetary surplus, current account surplus, and low public debt);

in terms of bonds, in our funds we only hold debt from Northern European countries and certain emerging countries;

in terms of equities, we confine ourselves to high-quality companies (low gearing, high profitability) and steer well clear of US and European financial stocks that most reflect the domestic problems of these regions. High dividends and emerging countries are key themes in our investment approach, and this includes US and European companies which derive a good proportion of their earnings from emerging markets. And we use derivatives (selling futures) to reduce the ‘market’ risk.

A Greek tragedy

2011-07-07T18:39:04+02:00

"Insanity is doing the same thing over and over again and expecting different results." (Albert Einstein)

Last week the Greek Parliament went ahead and adopted a new austerity bill which will see the European Union and the International Monetary Fund (IMF) pay another 12 billion euro tranche to Greece and the implementation of a new bail-out plan for the country. Alongside this, French banks' plans to voluntarily roll over Greek bonds to avoid Greece defaulting in the strict sense of the term seems to be gaining support. The scene is therefore set for the Greek tragedy to continue.

Will Greece ever manage to pay back its debt?

Last week’s vote and the 12 billion euro injection will win some time for the country. However, it does nothing to alter the reality that Greece will never be able to pay back its debt and that it will never be able to finance itself in the market at reasonable rates as long as that debt hangs around its neck. The austerity measures laid down in the plan adopted last week are far from credible. And even if they were, they would still further undermine economic growth, increase unemployment, reduce fiscal revenue (in the first two months of the year, Greece’s fiscal revenue was down 8%, in contrast with the IMF's plan predicting an 8% increase) and make the weight of the debt even more untenable. Similarly, the French banks’ plan is first and foremost a rescue plan – for French banks, and even for European and American banks, but does nothing to lighten the load of the debt currently weighing down on Greece. In light of this, comparisons with the Brady plan, set up in 1989 to deal with the debt problems in Latin America, make no sense. The Brady plan was designed to significantly reduce the Latin American debt problem by allowing banks to convert their loans to the region into 30-year loans guaranteed by the US Treasury but issued at a discount of 35% to the original value.

Pragmatism or sheer madness?

Some will praise the pragmatism with which the European authorities are managing this crisis. Little by little, such pragmatism has led them to break the rules laid down in the European treaties. The measures implemented were justified by the need to prevent the contagion to other peripheral countries and protect the European banking system. Others deplore the fact that this pragmatism goes against common economic sense by ignoring a fundamental rule, which is that a problem of overindebtedness cannot be resolved by adding even more debt. Added to this is the fact that tension is starting to appear amongst Greece's lenders with Germany in particular calling for a greater contribution from private investors. The European Central Bank is categorically opposed to this given that its balance sheet is already polluted with Greek loans.

Greece is not competitive

From an economic point of view, the logical conclusion is that Greece will have to default on most of its debt and adopt structural reforms to radically change its economic model and devalue its currency if it wants to see the light at the end of the tunnel and avoid years (and decades) of economic gloom. The last point obviously directly affects the survival of the single currency in its current form. Greece's problems are not just debt-related; the country is principally suffering from a lack of competitiveness. Keeping the country enclosed in a monetary union with much more competitive countries condemns it to a rather bleak future.

Economic divergences between eurozone countries

Despite numerous economic objections, the euro was implemented for political reasons to stabilise the European economy and speed up integration. The economic objections focused on the fact that by divesting the countries of their control over their currencies and monetary policies, they would lose their ability to react to changes in their economic situation. This was not necessarily an issue as long as the countries concerned were strongly integrated economically, but might become a very serious problem once the monetary union began to include countries that were less strongly integrated economically. The politicians' response was that the single currency would bring about economic integration - and in turn political integration.

In an ideal world, this might have worked. Taking away the control over the currency could have provided an incentive for the southern countries to implement the necessary structural reforms to improve their productivity and growth potential. Allowing them to enjoy the same interest rates as Germany (and therefore much lower rates than those to which they were accustomed), and consequently lower costs of financing, could have resulted in an improvement in their public finances. The reality is that the opposite has happened. The fall in interest rates has led to excessive consumption and speculative bubbles and given rise to a deterioration in budgetary discipline. At the same time, rising labour costs have reduced competitiveness, which is reflected in the relentless increase in the external deficit, making these countries more and more reliant on foreign capital. If these countries had not been members of the eurozone, the appearance of such deficits would have set off the alarm much earlier and we would not have reached the stage we find ourselves in today.

The ostensible aim of the euro - to promote greater integration between the eurozone economies - has not been met. While such integration was achieved in the decades preceding the introduction of the single currency, this has not been the case in recent years. The current situation will further increase the economic differences between the eurozone countries - if only because the northern countries are benefiting from very low costs of financing in contrast to the peripheral countries.

Which kind of governance for Europe?

The current crisis is therefore raising questions about how Europe is to be governed in the 21st century. Even today, the European authorities believe that the single currency must be defended at all costs and that proposals to abandon or overhaul the euro are quite simply unthinkable. Their attitude is summed up in the statement made by German Chancellor, Angela Merkel at the Davos forum: "Should the euro fail, Europe will fail." This reflects a certain arrogance - or at least ignorance of economic history that shows that there are many more examples of monetary systems or unions that have not survived than those that have. Another point is the 'at all costs' aspect, which is becoming a concern, as the financial and human cost of past errors is starting to mount. In a recent paper "The fate of the euro" by Woody Brock, founder and president of the firm, Strategic Economic Decisions, he writes that the ultimate aim of governments should be to adopt policies that maximise the well-being of the greatest number. Ignoring this objective is likely to make the euro the emblem of a Europe that has been forced upon the people but not desired by the people.

Towards fiscal union?

Many observers believe that the solution to the current crisis is greater political integration and, notably, fiscal union. Admittedly, the absence of fiscal transfer mechanisms between the countries is one of the major weaknesses of the single currency. And to the extent that the euro is above all a political construction, such a union could theoretically be decided and imposed on its citizens.

To some extent, the euro is a leftover from the Cold War, when there was a clear separation between the western and eastern countries of Europe. The economic and political interests of the western countries, as well as their concerns about national security, were relatively similar. Today, the economic and geopolitical links between the eurozone countries are less solid. In economic terms, Germany has stronger trading links with Poland and the Czech Republic than with Spain, Greece, Ireland and Portugal put together. In geopolitical terms, Germany is strengthening its ties with Russia while countries like Poland or Romania feel threatened by that country's resurgence. Fiscal union means a loss of political independence. It is hard to believe that Germany will share its sovereignity in terms of taxation with countries whose economic and geopolitical interests are no longer strongly aligned with its own. From a broader perspective, Europe cannot finance Greece, Ireland and Portugal to the same extent that Western Germany was able to bail out Eastern Germany without provoking revolt amongst its citizens.

One can understand the European authorities' reticence to overhaul the euro in the midst of a crisis and their efforts to take measures to stabilise the situation and gain time. However, it would be reassuring to know that they have a plan B, especially since a lot of time has been lost with incoherent measures (are they concerned about saving Greece or the banks? Do they want to help or punish Greece?) Consensus is building towards the thinking that the euro project is no longer workable in its current form and that it is better to cut losses now rather than to throw good money after bad.

BL-Global Flexible - Situation as at 10 June 2011

2011-06-15T15:57:58+02:00

Macroeconomic and financial environment – Important factors for the management of the fund:

- The latest indicators confirm the fragility of the economic recovery in the United States. In previous economic cycles, there was a direct link between the severity of the recession and the strength of the recovery: the more severe the recession, the stronger the recovery that followed. This relationship has been broken in the current cycle. The weakness of the current recovery is particularly apparent in everything that affects consumers. There are fewer jobs than in 2000, despite the population growing by around 30 million. Only 20% of jobs lost during the recession have been made up again in the recovery. Average salaries are falling in real terms (i.e. adjusted for inflation). Following a period of stabilisation, house prices are falling again. The weakness of the recovery is all the more surprising given the scale of the unprecedented stimulus measures put in place by the fiscal and monetary authorities. In a strongly indebted economy, these measures are having less and less impact and are actually endangering the solvency of the United States;

- The European economic environment is dominated by debates about the wisdom of restructuring Greek debt and tensions are starting to emerge, particularly between the European Central Bank and the German government. Current problems are bringing to light the fundamental flaw in the construction of the single currency. The exposure of European banks to the sovereign debt of the peripheral countries and of US money-market funds to paper issued by European banks has the makings of another systemic crisis. In this respect, it is shocking to see how little has changed since the 2008 crisis and that enormous risks still weigh on the financial system;

- The economic fundamentals of the developing countries are in much better shape than those of the main industrialised countries. These countries are currently having to deal with inflationary pressures due to rising commodities prices, particularly food. The authorities there have introduced monetary tightening, which has weighed on the region's stock markets. In the past few weeks, a number of fears about a hard landing and a credit crisis in China have also come to light, but these fears seem unfounded, at least for the time being. The emerging markets will gradually take over from the United States as the driver of the world economy;

- Based on normalised earnings, the US and European markets are overvalued. but within markets, there are some attractive pockets of opportunity.

- Government bonds have become a structurally unattractive asset class. This conclusion has been reached based on the currently very low level of long-term interest rates, which is reducing the return potential and increasing the volatility of bond investments. As well as this, the unprecedented deterioration of public finances in many countries means that government bonds are starting to lose their ‘risk-free’ character. Measuring the risk of a portfolio in terms of its equity allocation is, in light of this, less and less relevant.

- World economic developments continue to support a strategy based on shifting the portfolio towards the emerging countries or towards companies located in the industrialised countries that generate an increasing share of their results in the emerging countries.

Asset allocation

We took advantage of the recent correction in the stock markets and some stocks to increase the net equity allocation to 57%. Starting with the gross allocation of 87%, we achieve this figure by hedging 30% of the allocation through the sale of futures on the stock markets.

Asset Allocation - BL-Global Flexible - June 2011

There are two advantages of a strategy that involves reducing the equity risk using futures over a strategy of ‘just’ holding 57 % in equities:

- It ensures that we do not have to hold 43% (i.e. the part not invested in equities) in money-market or bond investments, which hold little attraction for the time being;

- It also allows us to invest the majority of the portfolio in the stocks of quality companies whose fundamentals are in much better shape than those of many governments, and which generally pay out attractive dividends. In our opinion, the particularly uncertain macroeconomic environment is continuing to favour a long quality/short market strategy. We believe that the quality of the companies in our portfolio is much better than the quality of the overall market.

In geographical terms, a positive growth differential and much better fundamentals are reasons for investing in the emerging markets. 19% of the portfolio is invested in the stock markets of these countries, particularly South-East Asia and Brazil.

24% of the portfolio is invested in US and Canadian equities, of which 14% is covered through the sale of futures on the S&P 500. In general, North American companies are selected from four main sectors - energy, healthcare, technology and non-cyclical consumption. A large portion of these companies’ turnover is generated outside the United States (mainly the emerging markets) meaning they are therefore well positioned to take advantage of any weakness in the dollar. 18% of the portfolio is invested in equities from the eurozone, of which 12% is covered through the sale of futures on the Euro Stoxx 50. As a broad general rule, eurozone investments tend to be made in defensive sectors with particular emphasis on the dividend component. The rest of the equity portion is invested in the UK (10%, of which 4% is covered through the sale of futures on the FTSE 100), Switzerland (6%), Japan (6%), Norway (3%) and Denmark (1%).

At the end of May, the equity portfolio's average price/earnings ratio was 13.3, and the average dividend yield was around 3.6% (gross).

10% of the portfolio is invested in bonds. Of this, 6.5% is invested in long-dated German government bonds and 3.5% in Brazilian real and Indonesian rupiah-denominated bonds.

Currency allocation

The currency allocation differs from the asset allocation in the fund. We use forward sales to lower the exchange rate risk on certain currencies or to increase exposure to other currencies. We aim to be exposed to the currencies of countries with strong fundamentals worthy of a AAA-rating and avoid countries whose fundamentals are deteriorating and/or where there is a higher risk of resorting to the printing press. This results in our partially covering the exchange rate risk on the US dollar, sterling and the yen. However, only a part of this hedge is done against the euro, given that the single currency is currently not inspiring a great deal of confidence either. A large portion of the USD, GBP and JPY exposure is hedged against the Singapore dollar, the Norwegian krone, the Canadian dollar and the Swedish krone.

Currency allocation before hedging - BL-Global Flexible - June 2011

Currency allocation after hedging - BL-Global Flexible - June 2011

Performance 2011

The net asset value of BL-Global Flexible has fallen by 3% since the start of the year. This is mainly due to the rise of the euro (the fund's reference currency) against most other currencies. The euro gained on average around 4.5% in 2011. As discussed above, only 36% of BL-Global Flexible’s assets are denominated in euro (after taking into account the currency hedging).

Year-to-date performance - BL-Global Flexible - June 2011

Equity markets at a crossroads

2011-05-24T11:59:39+02:00

The history of the stock market shows that there are two main types of markets:

- Structural bull markets

- Structural ‘sideways’ markets, or markets showing no particular trends or in which prices stay ‘flat’. In his excellent book 'Active Value Investing', Vitaliy Katzenelson (1) also uses the term range-bound to describe this type of market.

I use the term ‘structural’ to refer to extended periods of around 10 to 20 years, such as the structural sideways market of 1966-1982, the structural bull market of 1982-2000, the structural sideways market of 2000-?, and so on.

The chart below illustrates these phenomena in the case of the Dow Jones Industrial Average.
Click here to enlarge chart

Source: Stifel Nicolaus

Within structural bull markets corrections of varying scale can occur (such as the stock market crash of 1987). For long-term investors, such corrections are not that significant, as the upward trend is well-established.

Within structural sideways markets, there are cyclical bull and bear markets (by cyclical, I mean movements of shorter duration ranging from a couple of months to a couple of years). The chart below shows these trends for the period 1998-2011. An investor investing passively in the index over this period would not have earned any money so to speak.

13 years with a lot of volatility
Click here to enlarge chart

Source: Bloomberg, Gluskin Sheff

The conclusion to be drawn from these two types of markets is not that equities should be shunned in structurally sideways markets, but that a much more active investment strategy is required. An active strategy is required in terms of the periods during which we want to be ‘in the market'; in terms of regions / sectors to which priority should be given, and in terms of the selection of companies in which we want to invest.

What is the link between the foregoing and the current situation?

Since March 2009, the significant rise in share prices has brought the markets to a crossroads. As investors, we have to decide which side we are on:

- Either we are on the side of those who think that March 2009 was the start of a new structural bull market;

- Or we are on the side of those who think that the period since March 2009 was just a cyclical bull phase within a structural sideways market.

In the first case, the best strategy is to stay invested and not focus too much on interim corrections, as it will be almost impossible to time these corrections.

In the second case, an investor should envisage a gradual exit from the market. At the very least, such an investor should carefully reexamine the rationale behind his or her equity investments.

Two years ago, the situation was different

An investor did not need to have a precise idea of the type of market he was in. Stock prices had just fallen by 50% and were at the bottom end of the range that had been prevalent since 2000. In other words, knowing whether the markets were on the verge of a cyclical or structural recovery was not important. Even those who were convinced that stocks were in a structural sideways market were able to take advantage of the cyclical recovery in stock prices. This is not the case today where the markets are in the upper range of the past 12 years.

Equity prices are in the upper part of their trading range

Source: Bloomberg

I have on a number of occasions discussed our conviction that we are still in a structural sideways market and that it will take years before western equity markets manage to sustainably exceed 2000 levels again. Structural bull markets start when stock valuations are low and end when valuations are high. Prices then stagnate while profits continue to rise. Stocks that were expensive in 1966, for example, become cheap in 1982 paving the way for the next bull market. The valuations observed at the end of the last bull market in 2000 were extremely high, which explains why even after 11 years of price stagnation and rising profits, equities are still not cheap.

Difference of opinion

I am aware that there is a difference of opinion on this point. Many observers consider that equities are cheap, which is an easy conclusion to reach if:

- equities are valued based on models using the currently very low levels of interest rates,

- we presume that companiesprofit margins, which are currently at historically high levels, will remain at these levels or rise even further. This is tantamount to betting against history, which shows that profit margins usually tend to return to their historical average. This seems logical in a market economy in which too-high margins attract competition, while rising competition has the impact of reducing margins.

One way of getting round the problem of the currently high levels of profit margins is to value companies based on their sales or their book value. Another is to take the average of earnings over a number of years. The chart below uses the price/earnings ratio developed by Robert Shiller, a Professor of Economics at Yale University, which divides the share price by the average earnings of the past 10 years to avoid using an exceptionally bad or good year. According to this ratio, the US market is currently overvalued by around 30%. It is true that European equities seem less expensive. This is nevertheless partly due to the composition of European indices and particularly the preponderance of financial stocks in these indices which seem cheap but are not necessarily so as illustrated in the recent capital raising exercise by Commerzbank.

Shiller PER for the U.S. equity market

Source: Morgan Stanley

Using artificially low interest rates to value equities seems risky to say the least. At Banque de Luxembourg Investments (BLI), we apply a 9% discount rate in our valuation models as a broad general rule. Lowering this rate to 6% would significantly increase the intrinsic value of the companies we analyse and reveal numerous buying opportunities. By doing this, however, we would reduce the margin of safety that we require in our investments.

Finally, interest-rate valuation models give an idea of the relative appeal of equities over bonds but reveal nothing about the absolute attraction of equities. It could be that in the next 10 years, equity returns beat those offered by bonds, but that does not mean that equity returns will be good. The history of the stock market shows that an investment in the US market at current valuation levels has on average generated an annual return of 3% in the following ten years.

(1) Vitaliy Katzenelson: Active Value Investing; Wiley Finance

Brazil: an economic success story

2011-05-06T10:53:44+02:00

In the past few years Brazil has experienced undeniable economic success. In 2010, growth exceeded 7% and current analyst projections for this year place the figure at above 4%. The country is the eighth largest economy in the world and accounts for 36% of Latin America’s gross domestic product.

The reforms behind the country's economic success

The reforms behind the country's economic success were implemented at the end of the 1990s under the Cardoso administration and consolidated at the start of the 2000s by the Lula administration. The reforms focus on two main institutional measures:

- The first was the budget responsibility law. This law, which came into force in 2000, enshrined in the constitution financial, budgetary and administrative restrictions imposed since 1995 by the federal government on the states. It basically prevents the federal government from lending to states and increases the legal and financial responsibility of governors.

- The second measure was the adoption of an inflation-targeting framework for conducting monetary policy. This involved setting an inflation target (currently 4.5% +/- 2%) that the central bank would be responsible for achieving using interest rates as its main policy tool. After a period of hyperinflation in the 1980s and the start of the 1990s, Brazil has experienced moderate inflation in recent years.

To improve its financial health

Both measures have enabled the country to improve its financial health. Over the past few years, Brazil has consistently posted a primary surplus (i.e. a budget surplus prior to interest payments on public debt), which has helped to stabilise the public debt / GDP ratio. The challenge for the coming years will be to improve the quality of this budgetary consolidation by lowering the tax burden and implementing reforms to reduce mandatory public spending, which today accounts for more than 70% of public spending. As far as the fight against inflation is concerned, it is important to note that Brazil’s central bank is still not independent and that its monetary policy is vulnerable to political decisions.

The rise in commodities prices

In addition to the reforms mentioned above, there is another extremely favourable factor for Brazil - the rise in commodities prices. Brazil is one of the major exporters of agricultural commodities, base metals and metal products. The surge in commodities prices has enabled Brazil to significantly improve its terms of trade (export prices / import prices) and boosted its trade balance as well as its exchange reserves. Whereas in the past, most of Brazil’s debt was denominated in USD, the country is today a net creditor in USD which makes it much less vulnerable to changes in foreign investor attitudes.

Facing a certain number of challenges

While Brazil’s economic success is based on relatively solid fundamentals, the country is nevertheless facing a certain number of challenges, the most important of which is infrastructure development. Despite its heavy tax burden, public spending in terms of investment is very low, as the major share of tax revenue is spent on current expenditure and social transfers, which safeguard the social peace and are usually required under the Constitution. Private investment is often discouraged due to the lack of credit, high intermediation costs and regulatory uncertainties. Moreover, using the private sector to develop infrastructure is often difficult to reconcile with an ideology that favours the continued control of the state. The World Cup in 2014 and the Olympic Games in 2016 should result in an increase in the investment component in Brazil's GDP. Currently this component is low compared to the other emerging countries, particularly China. On the other hand, the share of private consumption is much higher in Brazil and in this respect the country is more like an industrialised country.

The potential for non-inflationary growth

The lack of infrastructure and shortage of qualified labour are limiting the potential for non-inflationary growth, particularly as the high proportion of the private and public consumption component in GDP puts Brazil in a chronic situation of excess demand. With capacity utilisation rates close to their peaks and unemployment around 6% (which, taking into consideration the high proportion of undeclared activities, corresponds practically to a situation of full employment), the country runs the risk of overheating. In light of this situation, inflation could exceed 6.5%, which is the upper band of the range set by the central bank in 2011. The shortage of qualified labour is all the more problematic at the present time given that the country would need productivity gains to face up to the appreciation in the real. The real has been boosted by large capital inflows in the form of direct and financial investments, the latter in part attracted by high interest rates, both in nominal and real terms (adjusted for inflation). In a bid to combat the strength of its currency, the government has started raising taxes on equity and domestic bond purchases (2% and 6% respectively).

BRL/EUR exchange rate

The evolution of the Brazilian stock market and interest rates

After a strong run between 2004 and 2007, the Brazilian stock market slumped by around 50% between May and November 2008, before staging a sharp recovery in March last year, which brought it back close to pre-crisis levels. Since then the index has lost around 10%. Three notable factors weighed on the market in 2010: the presidential elections, Petrobras’ capital raising effort (the biggest rights issue ever) and monetary tightening by the Brazil Central Bank. While the impact of the first two factors has since disappeared, monetary tightening is still an issue as seen in the recent decision of the BCB to raise its key interest rate again. Since April 2010, the rate has risen from 8.75% to 12%. With real rates close to 6%, there is little incentive for local institutional investors to invest in equities.

BOVESPA index over 5 years

However, at 11 times estimated 2011 earnings and 1.7 times book value, the valuation of the Brazilian stock market is today relatively attractive in absolute and relative terms (i.e. compared to other emerging markets). As with most of the emerging markets, domestic opportunities are not really reflected in Brazilian indices as these are dominated by stocks such as Petrobras and Vale. In our BL-Emerging Markets fund, we are invested in four Brazilian companies: Lojas Renner (retail), M Dias Branco (food), Natura Cosmeticos (beauty products) and Weg (industry).

BL-Global Flexible Q1 2011

2011-04-12T08:47:14+02:00

BL-Global Flexible's net asset value fell 3.7% in the first quarter of 2011 due to various factors that weighed on the fund’s performance over the quarter:

- The fund’s reference currency, the euro, has risen against most other currencies. Only 40% of BL-Global Flexible’s assets are denominated in euros;

- BL-Global Flexible does not invest in financial stocks from the industrialised countries: these sectors made strong gains in the first quarter. At the other extreme, the more defensive sectors, in which the fund prefers to invest underperformed, and in some cases even declined;

- In this context, the fund’s strategy to hedge part of its equity exposure through the sale of index futures had an additional adverse impact on performance.

There were no significant changes to the fund’s asset allocation over the quarter. Bonds were slightly increased following the rise in long-term interest rates between September and February. By the same token, the correction on some stocks was used to increase their weight in the portfolio, which boosted the net equity allocation from 43% to 48% (82% of which 34% are hedged through the sale of futures). By the end of the quarter, the average PE of the equity portfolio was 13, while the average dividend yield was 3.6%.

BL-Global Flexible is an actively managed non-benchmark fund that is guided by fundamental analysis. Our main convictions are currently as follows:

- The recovery in the economy – and in turn on the stock markets over the past two years is to a large degree artificial and thus fragile. A significant slide in share prices can not be ruled out;

- The monetary policies conducted by the central banks - and the Federal Reserve especially - have incited investors to take more risk. This has resulted in a significant outperformance of cyclical and financial sectors and small and medium caps. These segments currently appear particularly vulnerable. At the other extreme, there are good opportunities within defensive sectors and large cap companies.

- The risk/return of government bonds has deteriorated given the low level of interest rates and rising public debt. Tactical opportunities do pop up from time to time, however. As in the case of equities, active management is called for as far as bonds are concerned;

- The emerging markets have much better fundamentals than the industrialised countries. In this respect, the weighting of the Southeast Asian countries in the portfolio will remain high.

Update on our investment strategy

2011-03-25T14:45:14+01:00

“The Buddha taught that you can only understand something by looking deeply at its interconnectedness to other things, and to our own selves – nothing has a separate existence. ‘This is, because that is; this is not, because that is not.’ The problems and imbalances that have inflamed the world did not emerge from a vacuum. Rather, this is, because that is.” (John Hussman)

1. My first point is that we are in a highly dangerous macroeconomic environment and that the long-term return prospects for most markets are low. The extraordinary monetary and budgetary measures have only provided a relatively mediocre economic recovery that is still very fragile. Broadly speaking, these measures are only the continuation of those that led to the crisis in the first place and are doing nothing to resolve the fundamental problems. More often than not, they have had counterproductive effects, with the Federal Reserve’s policy contributing to the hike in commodities prices and the fall in the dollar, which have resulted in a decline in US consumer purchasing power. The measures have also led to an unprecedented deterioration - in peace times at least - in the public finances of the industrialised countries. The upshot is that if another crisis was to emerge, the authorities would have practically no room for manoeuvre.

2. The economic stimulus measures have led to a strong advance in stock prices over the past two years and pushed the markets to levels that strongly impede their long-term return potential ('the price paid determines the return' is still the most important rule in investment). Arguing that you should buy stocks because interest rates are low and bonds are unattractive is stupid and does not hold water from an historical point of view.

3. In light of the above, our investment strategy will maintain a strong defensive bias (unless the markets slump, which would bring stocks down to much more attractive levels). Of course, we are aware that a new round of monetary easing in the United States could prolong the stock market rally of the past two years. It is our opinion, however, that participating in this rally involves a great deal of risk. Contrary to financial theory which equates risk with volatility, we believe that the main risk for an investor is the loss of his capital. In other words, a strategy that produces moderate gains in 80% of cases but huge losses in 20% of cases is not acceptable for us.

4. It is important to note that having a defensive strategy does not mean that we are avoiding stocks. The traditional distinction between equities as risk assets and bonds as no-risk assets no longer makes sense in the current climate where businesses are often in better financial shape than governments. There seems to be little long-term upside potential from current levels for the stock markets, but within markets, there are attractive pockets of opportunity. Our investment themes are still ‘quality companies in defensive sectors’, ‘dividends’ and ‘emerging markets’. In terms of fixed income, some of the emerging markets are also offering a much better risk/return trade-off than bonds in most of the industrialised world.

5. As far as the events in Japan and the Middle East are concerned, one thing seems clear – they are putting further upside pressure on oil prices, thus increasing the prospect of an energy crisis. In the industrialised world, soaring oil prices are a deflationary not an inflationary event. They reduce consumers’ buying power and exert downward pressure on profit margins. In the United States, real wages (adjusted for inflation) fell in five out of the six past months.

6. Rebuilding Japan’s destroyed infrastructure will require raw materials and in turn support prices of these raw materials. Once again, it is important to point out that unlike in the past when rising commodities prices were usually a consequence of the strength of economic activity in the industrialised countries (and had therefore an inflationary bias), today this increase is resulting from the strength of economic activity in the emerging markets and geopolitical factors, and has therefore a deflationary impact on the industrialised countries. The fears of contamination of the food supply chain does nothing to reduce the inflation in global agricultural prices.

7. The tragedy in Japan has happened at a time when the Japanese government is facing huge debt and where the savings (of its population) required to support this debt are diminishing as its population ages. There are fears that the Japanese authorities will in turn resort to large-scale quantitative monetary easing (a euphemism for printing money). With the confidence in the dollar largely undermined, the euro could remain the default currency despite the problems within the eurozone. In the longer term, this situation could result in a new monetary order in which the emerging creditor countries would accept to revalue their currencies as the price to pay for being able to conduct independent monetary policies. Current inflation trends in these countries, the result of rising commodities (especially food) prices, could accelerate this process.

8. The fact that many strategists are recommending using the correction in the wake of the events in Japan to buy stocks is quite revealing of a state of mind that believes that any slump in share prices is a buying opportunity. First of all, the correction is negligible in light of the rally of the past two years. Second, risks are plentiful given the events in Japan, Bahrain, Yemen and Libya, the debt crisis in Europe, monetary tightening in China, and the prospect of the end of QE2 (the second round of the Federal Reserve’s extraordinary monetary easing) in the United States (1). Many markets have doubled in value since March 2009 and it would be naïve to think that these risks are currently factored into prices.

9. The Japanese stock market itself is currently relatively cheap. Companies are trading on average at one time their book value, compared to other countries where this ratio is well above two. As well as this, Japanese companies’ return on equity, traditionally low, is starting to improve.

10. In conclusion, the events in Japan and the (slight) correction in equity prices do not constitute a buying opportunity. In March 2009, stocks were trading at relatively attractive levels, and the economy and corporate earnings had begun to improve. Today, we are in the opposite situation. The rally of the past two years constitutes an opportunity to undertake a fundamental repositioning of investment portfolios, however, away from those countries whose fundamentals are deteriorating and towards those whose fundamentals are sound or improving.

(1) The end of the first round of extraordinary monetary easing in April 2010 led notably to a 12% correction in the S&P 500 and aroused fears of a return into recession. It was this situation that prompted the Federal Reserve chairman, Ben Bernanke, to hint at a new round of monetary easing as soon as the end of August. Today, some members of the Federal Reserve Open Market Committee are already talking about the need for QE3.

Investment strategy 2011 (fourth and last part)

2011-03-15T15:50:54+01:00

Defensive sectors have significantly underperformed during the stock market recovery of the past two years.

A number of factors are prompting me to think that this situation is coming to an end and that there are now grounds to give priority to these sectors, particularly telecommunications, healthcare, and food/tobacco:

- Our conviction that the economic recovery remains fragile. Independently of structural impediments to growth, linked to overindebtedness, economic activity could start to be negatively impacted by the increase in the price of oil and rising interest rates. In such an environment, the relatively stable earnings of defensive quality companies will once again be appreciated;

- Defensive sectors regularly go through phases of under- or outperformance, but the underperformance of the past two years is extreme from an historical point of view;

- The logical outcome of this underperformance is that the valuation of these sectors is currently attractive in absolute terms and very attractive in relative terms (i.e. compared to the overall market and cyclical sectors);

- Unlike cyclical sectors, the profit margins of defensive sectors are still well below their previous peaks;

- Certain defensive sectors are strongly exposed to the emerging markets where there is higher growth potential.

A final note is that the underperformance of defensive sectors goes hand in hand with the huge underperformance of large caps in the past few years. The following graph shows that over the last 10 years, large caps (and the general market) have been drifting sideways while small and mid caps have generated an annualised return of around 8.5%. This was due to the fact that at the start of 2000, large caps were very expensive compared to small and mid caps. The opposite is true nowadays.

Investment strategy 2011 (third part)

2011-02-18T08:54:59+01:00

Dividends

Investing for the long term in dividend-paying companies makes a lot of sense. Many empirical studies show that in the long term, buying high dividend stocks is one of the best ways to combine attractive returns with less volatility. Despite this evidence, dividend stocks are often overlooked as investors prefer to buy high-growth stocks whose price appreciation potential is perceived to be more important.

One of the most exhaustive studies on the contribution of dividends was written by Robert D. Arnott, the founder of Research Affiliates. In an article published in 2003 in the Financial Analysts Journal, he analyses the sources of return from US stocks over a period of 200 years, from 1802 to 2002. He shows that over this period, US stocks generated an annualised return of 7.9%, of which 5% came from dividends, 1.4% from inflation, 0.6% from rising valuation levels and 0.8% from the real growth in dividends.(1)

The good results in terms of risk / return produced by a dividend strategy are hardly surprising. On the qualitative side, a high dividend helps to determine the quality of a company’s results and its financial health. On the quantitative side, the dividend provides some 'yield support' for the stock and, when reinvested in bear markets, helps to reduce the time needed to make up capital losses. As well as this, high dividend stocks tend to be attractively valued in relation to their earnings or book value.

The advantages of dividend stocks can only be appreciated over reasonably long investment horizons exceeding a number of years. Moreover, empirical studies also show that the best returns are generated by strategies combining high dividends and a low POR (pay-out ratio - the share of profits distributed in the form of dividends). This seems logical as a too-high POR undermines the sustainability of the dividend.

During the bull markets of the 1980s and 1990s, dividends lost much of their importance – especially in the United States, where they were heavily taxed. The outcome of this is that investors tend to associate the return on a stock with the growth in the stock price forgetting about the dividend component. As well as this, against a backdrop of increasingly short investment horizons and investors looking for the next Google or Apple, dividend strategies do not seem very exciting (neither Google nor Apple currently pay out dividends).

Demographic trends and the ageing of the population could nevertheless result in a change in investor attitudes. Investors will increasingly seek regular income and consequently a larger share of the return on stocks in the form of dividends rather than capital gains (especially since, based on current valuations, it seems illusory to think that the US and European stock markets can produce much more than 4% in real terms annually in the coming years). One could even make the point that given the decline in the 'risk-free’ reputation of government bonds, stocks from quality companies with low levels of debt and paying reasonable dividends could take over from bonds as the default investments in defensive portfolios despite their higher volatility.

Finally, in an environment in which many investors fear the return of inflation, it is important to point out that, unlike a coupon on a bond which is usually fixed, a company can increase its dividend. Dividend stocks therefore offer some protection against inflation.

Our conviction about the long-term validity of a dividend strategy was the impetus behind the launch of our dividend fund, BL-Equities Dividend, just over three years ago. The chart below shows the fund’s performance since launch (November 2007) and its comparative performance against the MSCI All Countries Index (in euro) and the same index with dividends reinvested. The chart confirms the comments above:

As far as the MSCI index is concerned, the reinvestment of dividends lowers the loss of an investment in this index from 12.3% to 6%;
The fund outperforms the index as it falls less in bear markets;
Despite one of the most important bear markets in stock market history, an investor buying the fund at launch would today be on a winning streak.

(1) Source: Robert D. Arnott: Dividends and the Three Dwarfs, Editor’s Corner, Financial Analysts Journal, 2003.

>> Investment strategy 2011 - Read on the fourth part

Investment strategy 2011 (second part)

2011-02-16T10:48:36+01:00

The emerging markets

The emerging markets are currently going through a challenging period. Since the start of the year, the MSCI Emerging Markets Index has lost 6% in local currency terms, contrasting with the industrialised countries, which have risen by just under 5%. The emerging markets’ underperformance is due to inflationary pressures that are starting to appear amid rising commodity prices - particularly food prices which represent on average around 30% of the CPI basket in this region. These pressures are forcing the region’s authorities to tighten monetary policy and raise key interest rates. Events in Tunisia and Egypt have also served to remind that the political risk remains high in certain countries. In an environment of short investment horizons, we are seeing a rotation towards the industrialised countries where monetary tightening is more of a far-off threat and where the latest macroeconomic data is on the whole better than expected. After the large capital inflows to the emerging markets in 2010, the past few weeks have seen significant outflows from these markets.

Before concluding that the recent absolute and relative performance of the emerging markets represents a strong investment opportunity, it is worth looking at this performance in a longer term context. Since 1990, a typical correction for the emerging markets was a 20% fall in share prices that usually lasted around six months. In this respect, the current correction of 6% over seven weeks could continue for a while. Such a scenario makes sense as long as the industrialised countries continue to benefit from a very favourable environment (better macroeconomic data and artificially low interest rates) and as long as investors are not convinced that the inflationary problem in the emerging markets is under control.

The current situation on the emerging markets and the good performance of the industrialised countries do not alter the economic and stock market reality, however. The growth differential between the emerging markets and the industrialised countries continues to favour an investment in the former. As a general rule, the emerging markets have much better fundamentals with, notably, a much lower level of debt. Their valuation is attractive in absolute terms with a price/earnings ratio of 11.8 for 2011 and in relative terms with a 15% discount to the industrialised countries despite a much higher profitability of emerging market companies. The fundamental attraction of the emerging markets is therefore not being called into question by the current correction.

The emerging markets are not a homogeneous class and it is important to differentiate between the various countries within this group. The chart below shows that three of the markets referred to as the BRIC (Brazil, Russia, India and China) countries have been underperforming the MSCI Emerging Markets index over one year, with a disappointing year on the stock markets in 2010 for Brazil and China in particular. We continue to give priority to the mature countries of Southeast Asia (which, for some, do not feature in the emerging market indices anymore).

>> Investment strategy 2011 - Read on the third part

Investment outlook 2011: quality companies and emerging markets - video

2011-02-10T14:22:42+01:00

Against a backdrop of a fragile economic recovery and low interest rates, priority should be given to quality companies and dividends in the industrialised countries, and to the stock markets and currencies of the emerging markets, particularly Asia.

This year, my analysis for 2011 is for the first time delivered in a short film.

BL-Global Flexible EUR: Performance since beginning of the year

2011-02-04T11:35:15+01:00

Everyone should be made aware of the insanity of it all, and that preserving their capital and growing it slowly and prudently is a totally appropriate strategy for this radical money easing environment. This type of policy breeds speculative and dubious rallies, but what they inevitably trigger are boom-bust cycles such as the ones we saw in 1999-2002, 2006-2009, and the current one we are in today. This is no time for short memories.
(David A. Rosenberg, Chief Economist & Strategist, Gluskin Sheff)

BL-Global Flexible has not performed well since the start of the year. I briefly outlined the reasons for this in my 24 January post, but I feel that it is worthwhile further exploring the reasons behind this disappointing performance.

BL-Global Flexible is characterised by a high conviction management style. By definition, this involves an active approach to management, not dictated by benchmark indices and based on our fundamental convictions and analysis of the economic and financial situation. In an ideal world, our convictions would always lead us to the 'right' decisions, but we know by experience that this is not the case. In the short term, notably, market fluctuations may go against our views. (It’s important to point out that we are not the only ones in this situation. A study by Tweedy, Browne, the investment management company, shows that fund managers who have widely outperformed their benchmark index in the long term have experienced many years of underperformance. These periods were usually characterised by strong bull runs where caution was penalised.)

That said, amongst the various factors that are currently penalising BL-Global Flexible (and Banque de Luxembourg’s funds on the whole), the following stand out:

- BL-Global Flexible does not invest in banking stocks or insurance companies from the industrialised countries. Yet since the start of the year, these sectors have progressed the most in Europe. At the other extreme, the more defensive sectors, in which the fund tends to invest, are lagging;

- In this context, the fund’s strategy to hedge part of its equity exposure through the sale of futures has an additional adverse impact on performance;

- The emerging stock markets have been underperforming in the past few weeks due to the resurgence of inflationary pressures. However, this does not make them less attractive from a medium- to long-term point of view;

- The fund’s reference currency, the euro, has risen against most other currencies. Only 40% of BL-Global Flexible’s assets are denominated in euros;

- The bond weighting was sharply lowered in the third quarter 2010 and the rise in long-term interest rates since September has not put the fund at too much of a disadvantage. With around 10% of its investments in bonds, the weighting nevertheless had a negative impact.

A poor performance of a fund in January is not particularly wonderful in a field in which a fund’s performance tends to be presented since the start of the year. We believe that the factors that have weighed on the performance of our funds are temporary, however. Most of these are linked to the perceptions of investors that the world economy is on the road to a strong sustainable recovery and that the European crisis is being resolved - two opinions we do not share. In light of these developments, we plan to continue with our current investment strategy and not make any significant changes to the composition of the BL-Global Flexible portfolio.

Investment strategy 2011 (to be continued)

2011-02-03T09:33:16+01:00

“I know what’s around the corner - I just don’t know where the corner is.” (Kevin Keegan)

2010 was a good year for the stock markets, which, for the most part, notched up gains of over 10%. Behind this figure, however, was a great deal of volatility. The US and the European markets were down by 6% at the end of August when Ben Bernanke, US Federal Reserve chairman hinted that the US central bank would engage in a new round of quantitative monetary easing. This announcement prompted a spectacular rally on the markets, which, at the time of writing, is still underway. The current situation seems to confirm the old stock market adage whereby you should never go against the Federal Reserve and that in the short term, liquidity has the upper hand over fundamentals.

The behaviour of the markets in 2010 is a good illustration of the dilemma currently facing investors. Generally speaking, structural problems persist. More specifically, the increase in public debt, soaring budget deficits and an undercapitalised banking sector will lead to significant problems in the industrialised countries. In the next three years, certain countries such as Japan, Italy and the United States (not to mention Greece, which currently has the advantage of not having to resort to the market for its funding) as well as the European banks will face huge financing requirements.

While the risks seem obvious, the fact is that the authorities, particularly in the US, are willing to do anything to perpetuate the cycle of overconsumption and overindebtedness and to boost the financial markets. Such a situation tends to favour risk-taking, especially in an environment in which the investment horizon is getting shorter and shorter and in a profession where many investments managers have taken Keynes’ advice as their careers guidance: "Never, ever be wrong on your own. You can be wrong in company; that’s okay." They feel obliged to follow short-term movements on the markets for fear of losing clients. Against a backdrop of renewed optimism at the start of 2011 about the economic situation and the ability of European countries to resolve the crisis, this trend is currently resulting in an aggressive sector rotation within the stock markets, with more defensive sectors being sold in favour of financial stocks.

The current rally in risk assets could thus continue for some time. Many observers have pointed out that we have entered the third year of a US presidential cycle, which is traditionally good for equities: since the 1940s, the US stock market has never been down in the third year of a presidential cycle. Moreover, the economic risks that can be detected for the stock markets in 2011 (disappointing company earnings, fears about the sustainability of the economic recovery) seem to be concentrated in the second half of the year.

Our investment strategy will continue to be driven by a fundamental analysis of the economic and financial situation. Based on this analysis, here are our recommendations for 2011.

1. Long-term government bonds

This recommendation goes against the advice of most experts, who believe that the deterioration in public finances and the devaluation of currencies by more or less explicit recourse to the printing press will result in a rise in inflation and push up bond yields, especially in a context of economic recovery.

I agree that the increase in public debt is very worrying. However, when I speak of buying long-term government bonds, I do not mean that they should be held until maturity, but that they should be kept for around 12 months. An active investment strategy is increasingly as important for bonds as it is for equities.

Why am I recommending bonds now? First of all, the sharp increase in long-term interest rates since September 2010: over the past five months, the 10-year German bond yield has risen by more than 100 basis points, from 2.1% to 3.2%. This means that over the same period, the 10-year German government bond price has lost around 10%. (In the United States, we have seen a similar increase in bond yields, which have risen from 2.4% to 3.5%, leading us to the conclusion that German bond yields are rising for reasons other than just the fear of seeing “Germany having to pay for Greece”.)

Second, the two factors which, in the past, have played a crucial role in determining bond yields are still good for the bond markets. The first is the monetary policy implemented by the central banks and the second is inflation. The Federal Reserve and the European Central Bank will take no risks with the economic recovery and will wait a long time before raising their key interest rates. At the same time, they are doing everything they can to keep down long-term interest rates (over which they have no direct control). In light of this, the significant gap between short and long rates should bolster the bond markets and attract a certain number of ‘natural’ buyers of bonds, such as banks or institutional investors interested in achieving a balance between their assets and long-term liabilities. In terms of the inflation factor, the main component, unit labour costs (wage costs adjusted for productivity gains), is almost non-existent. Finally, I continue to believe that the economic recovery in the industrialised countries is generally artificial, because it is being driven by fiscal and monetary stimulus measures that the authorities will not be able to sustain, and statistical, in light of the significant stock replenishment by companies. Doubts on the sustainability of the recovery, particularly in the United States, could reappear later in the year, in a mirror image of last summer’s events, which prompted the Federal Reserve to engage in a new round of quantitative easing.

Two points should be underlined:

- The price of a long-term bond is highly sensitive to any rise in interest rates. If, contrary to my expectations, long-term rates rise by another 100 basis points between now and the end of the year, an investor holding a 10-year bond will have lost around 5%, including the coupon. The low level of long rates means that any increase in these is felt strongly in the price of a long-dated bond. There is therefore greater risk and volatility involved in investing in these kinds of bonds. In other words, when bond yields are at 3% and rise by 50 basis points to 3.5%, this hurts much more than if rates rose from 7% to 7.5% (what is true in one respect, is obviously also true in the other).

- As I said above and in previous posts, the increase in public debt is a major concern. Some countries are in a vicious circle and will find it difficult to avoid debt restructuring. Investors should therefore focus only on countries with better fundamentals.

>> Investment strategy 2011 - Read on the second part

Presentation BL-Global Flexible EUR

2011-01-31T11:30:44+01:00

To download a presentation of the general characteristics of BL-Global Flexible EUR and of its portfolio as at mid-January, please click on the following link.

Banque de Luxembourg Bl Global Flexible EUR

BL-Global Flexible EUR- Situation as at 24 January 2011

2011-01-26T14:28:54+01:00

After suffering from the rise of the euro in September (cfr my post from 4 October 2010), BL-Global Flexible EUR’s NAV (net asset value) had a satisfactory last three months of the year. The fund’s 3.8% gain in the fourth quarter allowed it to end the year up 12.60%.

Since the start of the year, the rise of the euro has come back to weigh on the fund’s performance. The euro has risen by around 2% against the dollar and the main Asian currencies, and by nearly 4% against the Swiss franc and the Japanese yen. As a reminder, more than half of the fund’s holdings are in currencies other than the euro, the currency in which the NAV is expressed.

Another factor that penalised the fund in the beginning of the year was its long/short equity strategy. Given the low level of interest rates, the fund tends to invest a large portion of its assets in quality companies and hedge part of the resulting equity risk by selling futures on the US, UK and European indices. This strategy is currently working against the fund. Stock market indices are being driven higher by sectors such as banks and insurance in which the fund does not invest, while the defensive sectors that the fund favours are being overlooked by the markets. By way of example, the chart below shows the performance of four sectors in the Stoxx Europe 600 index since the start of the year: banks, insurance, food&beverage and healthcare.

At the start of October 2010, I wrote that the rebound of the euro and the underperformance of quality companies, which had dragged down BL-Global Flexible EUR’s performance in September, would not last and that fundamentals would get the upper hand again. I think that this will again be the case in the next weeks and months. Events that could, in my opinion, bring about a shift in the currently very positive investor psychology include new fears on the sustainability of the US recovery, a deepening of the European crisis and the reaction of the authorities in the developing countries to inflationary pressures, which are starting to mount in these regions.

In sum, BL-Global Flexible EUR’s investment strategy at the start of this year remains unchanged. The macroeconomic environment remains characterised by major macroeconomic problems and overvalued stock markets on one hand, and, on the other, very low interest rates and - within stock markets - quality companies that are attractively valued and often paying out attractive dividends. This environment will continue to support a long quality / short market strategy. In geographical terms, the growth differential and much better fundamentals continue to favour the developing markets, which is why we continue to give priority to Asia. Finally, we are starting to take advantage of the sharp rise in long-term interest rates to boost our bond holdings in the portfolio.

Thoughts on the European crisis

2010-12-08T16:01:46+01:00

Some thoughts about the European crisis
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually, and then suddenly.”
(Ernest Hemingway: The Sun Also Rises)

After being relegated to the background by expectations of a new round of monetary easing by the Federal Reserve, the problems in the eurozone have resurfaced again. Here are some of my thoughts about this:

- Greece and Ireland’s problem is one of solvency and not liquidity. Levels of debt in these countries quite simply exceed their ability to honour their debt. Lending to Ireland at a rate of 5.82%, as decided by the Eurogroup and the EU finance ministers on 28 November, will not improve the ability of the country to repay its debt;

- A solvency problem is not resolved by adding more debt to the pile. A company in debt has three main choices: either it restructures its debt, it raises more capital, or increases its ability to repay debt by increasing its cash flow. For a country to 'increase its cash flow', nominal growth has to exceed the interest rate that it pays on its debt. By doing this, the country lowers its public debt to Gross Domestic Product (GDP) ratio and enters a virtuous circle. On the other hand, if the interest rate paid on the debt exceeds its nominal GDP growth, the country enters a vicious circle. Germany is currently in a virtuous circle; the peripheral countries (Southern Europe and Ireland) are in a vicious circle;

- The fact that the core (Northern Europe) countries are managing to finance themselves at attractive rates (partly due to the crisis) while the peripheral countries pay increasingly exorbitant rates further widens the competitiveness gap between these regions. The gap exists because of diverging unit labour costs (labour costs adjusted for productivity gains) and is the main challenge for the survival of the euro in its current state. Diverging trends in labour costs are mainly due to the fact that the peripheral countries did not take advantage of the low interest rates they inherited when they first joined the eurozone to clean up their public finances or undertake productive investments. What the low interest rates did do, however, was to create a situation of excessive consumption and soaring house prices;

- As members of the eurozone, these countries do not have the possibility of resorting to currency devaluation to restore competitiveness. Any rebalancing will have to be done by focusing on labour costs, which must rise much more slowly in the peripheral countries than in the core countries. Given that labour costs are almost stagnant in the core countries, this means that they will have to fall in the peripheral countries. Such an adjustment is painful and would involve a drastic reduction in the standard of living, which is not likely to be accepted by the population;

- The budget austerity measures generally recommended by organisations such as the IMF do not work in the current situation. The fall in public spending and the rise in taxes result in lower economic growth and affect tax revenue. This in turn leads to a worsening in the budget deficit and the debt level and the need to embark on new rounds of austerity measures, and so on. In the past, a country experiencing a crisis brought about by escalating debt or a weakened banking system could resort to austerity packages and currency devaluation, while taking advantage of strong international growth. Today the debt problem, the fragility of the banking sector and weak nominal growth is common to most of the industrialised countries. In this context, large-scale budget austerity without currency devaluation is tantamount to economic suicide;

- The problem in Ireland is mainly caused by the banking sector. The recent crisis was spurred by the increase in the cost of bailing out the Irish banks. Its desire to prevent its banks (which have become too big compared to the size of country) from going under pushed the Irish budget deficit sky-high. Iceland made the opposite decision: it decided to let its banks fail – their debt had risen to over10 times GDP. Iceland is currently experiencing a severe recession, but the country is starting to see the end of the tunnel, thanks also to a sharp currency devaluation. This is not the case for Ireland, where unemployment has already risen to 13% (according to the OECD, unemployment in Iceland is expected to peak at 8.1%) and a brain drain is already underway;

- Overall, the distinction between countries and their banks is becoming increasingly blurred. The reasoning becomes circular - on one hand, we cannot let Greece or Ireland restructure their debt because this debt is often held by German, French or other banks which would then suffer significant losses, putting the world financial system in peril. On the other hand, the vulnerability of the banking sector is likely to require government intervention, which will exacerbate the public debt crisis and the prospect of debt restructuring in certain countries;

- In a crisis situation, any credibility lost by governments is dangerous and likely to create a self-fulfilling prophecy (i.e. investors sell/stop buying a country’s bonds because they expect that country to default. This leads to an increase in the cost of financing of that country and brings about the default expected). Their credibility is already starting to wear down: the Irish banks behind the latest episode of the crisis had passed the stress tests in summer; Ireland was supposed to help out with the bail-out of Greece, and the announcements of 28 November do not seem realistic. In a recent note , Dylan Grice, the brilliant strategist at Société Générale, showed that the reaction of the European politicians to the crisis was typical of human behaviour when faced with events unforeseen and beyond our control:

denial that there is a problem,
denial that there is a big problem,
denial that the problem has anything to do with us.

- It is important to note that the rise in bond yields of countries like Spain and Portugal is not due to “speculation”, but to investors’ selling off (or not buying) bonds that they would have traditionally held. As an asset class, government bonds are supposed to offer security, liquidity, low volatility and negative correlation with risk assets. Those of the peripheral countries no longer offer these characteristics and are losing their natural pool of investors (pension funds, insurance companies, etc);

- Since the announcement of the bail-out of Greece in May, the 10-year German Bund yield slipped 10 basis points (0.10%), while in Italy, the bond yield rose by 50 basis points, 110 basis points in Spain, 320 basis points in Portugal and 360 basis points in Greece. These yields do not exist in a vacuum - they are the cost that countries would have to bear for their (long-term) financing needs if they had to go to the market (which will be the case at the latest in 2013 when the stabilisation fund runs out). Rising yields and the increase in credit default swaps (the cost of hedging against payment default) for the peripheral countries shows that investors do not trust the ability of these countries to pay back their debt;

- The survival of the euro in its current form depends very much on Germany. As long as the country believes that the advantages of the euro far outweigh the disadvantages, it will deploy efforts to support the currency. The problem is that the disadvantages could rapidly gain in importance: if Germany guarantees (or pretends to guarantee) the debt of problem countries, its creditworthiness will diminish and its cost of financing will increase (since October, we have seen a sharp increase in long-term German bond yields). Moreover, the country is currently experiencing robust economic growth and many companies have announced salary increases for next year. Germany has traditionally been very sensitive to risks of inflation, and a decision by the European Central Bank to keep interest rates very low (in order to help the peripheral countries) in such a situation could lead to problems in the long run;

- It has always been said that the euro was a political construction rather than an economic one. The current crisis could result in greater political integration and a kind of fiscal federalism. The eurozone would then become a large family where each would take care of the other (and bear the other’s debts). One way or another, this means that taxpayers in the core countries will have to pay the bill for bailing out the peripheral countries (rather than the one for recapitalising their banks if the peripheral countries restructure their debt). It will be very difficult for the core country governments to get voters to accept this situation;

- Current debates about a mutualisation of sovereign bond issues are moving in this direction and are the logical next step with regard to the Eurogroup’s decision of 28 November to downgrade government bonds to the status of subordinated bonds: "In all cases, in order to protect taxpayers' money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan." In other words, countries having received an official loan from the IMF or as part of the European Stability Mechanism (ESM) will have to pay this back first before paying back government loans. This decision means that in future, there is a greater risk that government bondholders will not get their investment back in full. And this will do nothing to solve the issue of the problem countries’ ability to finance themselves in the market at reasonable rates;

- Barring the implementation of a fiscal transfer mechanism, it is difficult to see how we can keep the euro in its current state, avoid debt restructuring in certain countries, protect the banks and come up with a solution for the Greeks and the Irish that would allow them to sort out their problems over a reasonable time frame. If anything is done, in my opinion, it will be necessary to try to break the ‘country-bank’ problem I talked about in the seventh point above. This could involve the recapitalisation of banks considered systemically important. In the current environment, I don’t think that the private sector will want to be involved in such recapitalisation, at least on a large scale. It would thus be up to the governments to inject the necessary capital by setting up a fund whose objective would be to recapitalise the problem banks in the eurozone region (why is Ireland forced to save its banks on its own when the failure of its banks would have a greater impact outside than inside the country?) I think that such a fund would make more sense than the European Financial Stability Fund (EFSF) set up recently to support eurozone countries in difficulties. Once the banks would get back on their feet again, the next step would be to examine how to restructure the debt of certain countries;

- In the end, the advantages of keeping the euro should be compared to the cost of the solutions required to save it. Burdening future generations with colossal debt just because the break-up of the single currency is 'politically unthinkable' is not acceptable.

Some thoughts on currencies

2010-11-18T11:53:08+01:00

Forecasting short-term and medium-term currency developments is extremely tricky. Despite this, investors need to have an overall framework for managing their currency allocation. Here is mine:

• The desire of many industrialised countries to debase their currency implicitly (via inflation) or explicitly (via depreciation or monetary reform) is a very worrying trend. It is a hidden form of protectionism that will result in more losers than winners;

• The two main currencies, the dollar and the euro, are both experiencing severe problems. In the case of the dollar, there is a greater risk of resorting to the printing press. The euro, on the other hand, is affected by the problems of its peripheral countries and the widening gap between Northern and Southern Europe;

• The dollar, until there is evidence to the contrary, is still a safe haven when investors become more risk averse. In the past three years, the dollar gained against the euro when the stock markets were falling and lost ground when the markets were rising;

• On the currency markets, the euro is ‘anti-dollar’. As long as China continues to show resistance to a more significant appreciation of its currency, the euro will be the default alternative for those wishing to exit from the dollar. The result is that when the dollar depreciates, it pulls down the Asian currencies with it, as well as other currencies such as sterling;

• The currencies of the industrialised countries which have sounder fundamentals and which seem less inclined to resort to printing money (Australia, Canada, Norway) have got rather expensive. At the other extreme, an ‘unloved' currency such as sterling currently seems cheap;

• Developing countries fundamentals are generally in much better shape than those of the industrialised countries;

• It is difficult to calculate the ‘intrinsic value’ of currencies. However, based on theories such as purchasing power parity, it would seem that the euro is around 10% overvalued against the dollar, which is in turn overvalued against the Asian currencies. In the long term, the dollar tends to correct its overvaluation or undervaluation against the European currencies. Its current undervaluation is not exceptional however. In the past 10 years, the dollar has been up to 25% undervalued (2008) and up to 20% overvalued (end 2000);

• Valuations and fundamentals are therefore calling for a long-term appreciation of the Asian currencies, especially since such appreciation would help to rebalance the world economy. It would also provide the Asian authorities with some ammunition in their battle against inflation, which is starting to appear in the region;

• The Asian authorities will nevertheless continue to oppose too rapid appreciations in their currencies as can be seen in the controls implemented by some of these countries (Taiwan, Thailand, South Korea, etc). Within the Asian region, it is important to differentiate: for example, the Thai baht is relatively expensive, while Hong Kong dollars, Taiwan dollars, and the Korean won are quite cheap.

Here is how these ideas are implemented in BL-Global Flexible:

The currency allocation of the fund is as follows:

EUR: 34%
USD: 29%
Asian currencies ex Japan: 12%
Currencies of other industrialised countries (CAD, NOK, JPY, CHF): 12%
GBP: 9%
Other: 4%

The dollar’s net exposure is reduced to 15% through forward sales against the euro and the Singapore dollar;

Sterling’s net exposure is reduced to 5% through forward sales against the euro.

The currency allocation of the fund after hedging is as follows:

EUR: 45%
Asian currencies ex Japan: 19% (including 11% SGD)
USD: 15%
Currencies of industrialised countries: 12%
GBP: 5%
Other: 4%

Quantitative Easing (Part 2)

2010-11-08T16:37:50+01:00

“Money may no longer be physically printed and distributed in the voluminous quantities of 1923. However, ‘quantitative easing’, that modern euphemism for surreptitious deficit financing in an electronic era, can no less become an assault on monetary discipline. Whatever the reason for a country’s deficit – necessity or profligacy, unwillingness to tax or blindness to expenditure – it is beguiling to suppose that if the day of reckoning is postponed economic recovery will come in time to prevent higher unemployment or deeper recession. What if it does not? It is alarming that some respected bankers and economists today, in the US as in Britain, are still able to commend ‘the printing press’ (in so many words!) as a fail?safe, a last resort. A country’s budget can indeed be balanced in that way, but at the cost, to whatever degree, of its citizens’ savings and pensions, their confidence and trust, their morals and their morale.” Adam Ferguson (2010)

As was widely anticipated, the Federal Reserve has decided to resort to a new round of quantitative easing. “QE2”, announced on Monday, will take the form of buying around 75 billion dollars of government bonds per month from now to the end of June 2011. Added to these new purchases will be some 30 to 35 billion dollars of coupon reinvestments which were expected anyway. The Fed’s objective is to create a wealth effect by inflating the value of financial assets and real estate prices which will then stimulate consumer spending and investment. In so doing, it is perpetuating the disastrous policy that began in the Greenspan era in the mid-1990s, which was in large part responsible for the structural problems that the United States is currently experiencing. Maintaining interest rates at artificially low levels has provoked a poor allocation of resources that has encouraged speculation to the detriment of productive investment. The Federal Reserve has thus confirmed that it has become a danger to the long-term economic health of the United States.

Unfortunately however, the decisions of the Federal Reserve ? the central bank of the principal reserve currency, the dollar ? do not only affect the United States but have repercussions across the global economy. As soon as the Fed signaled in August its intention to embark on this new round of quantitative easing, the dollar depreciated massively. Its decline was particularly marked against the euro given that the Asian currencies, the logical candidates for appreciation in view of their good fundamentals, are more or less correlated to the dollar. By encouraging, explicitly or not, their currency to depreciate in order to stimulate their exports, the United States are adopting a form of protectionism that is in danger of aggravating the global economic problems. In this regard it is ironic to note that, by pushing up commodities prices, the fall in the dollar is further increasing the problems of the American consumer ? witness, for example, the price of oil which has gone up by nearly 18% in the last two months.

USD/EUR exchange rate over 1 year

For fund managers, QE2 poses an additional problem. It is likely to prolong the decorrelation between the financial markets and economic reality. While a casual observer could thus think that the 16% rise in the US stock market since the end of August is based on improved economic fundamentals in the United States, in reality, this increase began with the announcement of further quantitative easing to come by the Fed’s chairman, Ben Bernanke. And, it is precisely because the economy is in such poor health that the central bank has decided to resort to this form of monetary stimulus.

S&P500 over 1 year

This divergence between the direction of the financial markets and that of the real economy could continue for some time to come (technically, the fact that the S&P500 has crossed the 1220-mark seems to be a positive signal). If it does, it is likely to test the patience and discipline of many investors who risk succumbing to the temptation of chasing the upswing, especially in an environment of very low interest rates. As many professional investors are judged on the performance of their portfolios against stock market indices, they feel cornered into taking risks on account of the monetary policies of the central banks, especially the Fed.

Trying to hook into short-term stock market runs is not an investment strategy however, especially when the trends are already well advanced and not based on solid fundamentals. The best way of protecting one’s capital and making it grow is to buy good quality assets at reasonable prices without being unduly swayed by the markets’ daily fluctuations. It is not a question of being bullish or bearish about equity markets but of identifying investments within these markets that meet this criteria. The themes to focus on remain the same:

emerging markets either by investing directly in the financial markets of these countries (nevertheless being aware that the local market indices are not necessarily a good way of investing in Asian growth given that they are often dominated by exporting companies), or via American or European companies that derive a significant portion of their revenues from these countries;
companies paying attractive dividends;
quality companies given that the premium at which they generally trade compared to the market and compared to lesser quality companies has disappeared.

BL-Global Flexible - Situation as at 1 October 2010

2010-10-04T11:34:47+02:00

In September, the net asset value (NAV) of the BL-Global Flexible fund fell by 1.67%. Since the start of the year, the fund has gained 8.49%. The fund’s poor performance in September may seem surprising given the strong rally on the markets in the past month and BL-Global Flexible’s (net) equity allocation of just under 40%. There are two main reasons for this:

- The rebound of the euro. Over the month, the euro advanced against all the other currencies, particularly the US dollar (+7.5%). As more than half of the fund’s assets are denominated in currencies other than the euro (even though the NAV is expressed in euro), we estimate that the decline in these currencies has cost the fund around 3% in performance;

Euro appreciation in the month of September

- The quality companies favoured by BL-Global Flexible have underperformed. While nearly 90% of BL-Global Flexible’s assets are invested in equities, a large portion (50%) of its equity exposure is hedged via the sale of futures on US, UK and European indices. This strategy can penalise the fund when quality companies underperform these indices.

Underperformance of quality companies

These phenomena can be explained by a somewhat strange scenario. In light of recent data confirming the generally fragile state of the economic recovery, the financial authorities – especially the Federal Reserve in the United States, are planning to embark on a fresh round of quantitative easing. This prospect has weighed on the dollar (fears of recourse to printing money) and boosted risk assets as it basically guarantees that extremely low interest rates will continue to dominate the environment. The prospect of quantitative easing has also pushed down investors’ aversion to risk. In this kind of environment, cyclical and financial stocks tend to outperform indices, while the opposite is true for more defensive stocks. In sum, the bad economic news has been a boon for the stock markets.

This situation will not endure and sooner or later, fundamentals will regain the upper hand. In terms of the currency markets, this implies that following a month in which market participants were preoccupied with the negative impact that the possible moves by the Federal Reserve could have on the dollar, the problems in the eurozone could once again become the main focus. On this point, it is worth mentioning that recent developments such as the rise in the cost of bailing out the banks in Ireland and Moody’s downgrading of Spain’s sovereign debt are hardly encouraging and do not really justify the recent strength of the euro.

Despite their good run in September, the (industrialised countries) stock markets have been fluctuating in a relatively narrow range for the past year. Unlike the bond markets, stock prices are not yet factoring in the economic reality characterised by weak nominal growth. There is no point forecasting short-term fluctuations on the stock markets, but I continue to believe that the next important move on the stock markets will be down. Apart from this, the themes of ‘quality’, ‘dividends’ and ‘emerging markets’ should continue to perform well – precisely the themes in which the equity component of BL-Global Flexible invests.

Asset allocation

(1) of which 48% is covered through the sale of futures

Currency allocation

Some alternatives to traditional fixed income investments

2010-09-28T15:30:49+02:00

In light of low government bond yields (the 10-year German bond yield has fallen below 2.4%) and the contraction of the interest rate differential between (investment grade) corporate and government bonds, investors need to get off the beaten track to get a higher regular income. Here are some suggestions:

Bonds denominated in other currencies: Quality bonds denominated in AUD, NZD and BRL are offering yields above 5% for example. There is an obvious exchange risk to be borne in mind especially in light of these currencies’ recent appreciation. We think that in the long term, their upward trend is set to continue given the sound fundamentals of these countries. Interim corrections should not be ruled out however, especially given that some of these currencies are perceived as being cyclical as they are linked to commodities. Given the interest rate differential with euro-denominated bonds, investors do have some margin of safety, however.

Example:
A Siemens 4-year bond denominated in euros currently offers a yield to maturity of around 2%. A Nestlé bond in Australian dollars with a similar maturity offers 5.2%. At current exchange rates, one AUD is worth 0.72 EUR. The interest rate differential is such that the Australian dollar can fall to 0.645 EUR (i.e. by around 10%) BEFORE the return on the Nestlé bond (when held to maturity) falls below the Siemens bond.

Total return over 4 years (in %)

AUD/EUR exchange rate over 5 years

Microfinance: Some Banque de Luxembourg funds have been investing in this area for two years with rather convincing results. The Bank has decided to launch a microfinance fund (BL Microfinance Fund) to offer its clients access to this asset class. It will be a closed-end (capitalisation) fund with a 3-year maturity (31/12/2013). The subscription period will start in October and the minimum investment is EUR 125,000. In light of current market conditions, the fund is targeting a net annual return of around 5%;
Euro-denominated bonds from riskier issuers - including government bonds (Greece, Portugal, etc), and corporate bonds. We do not hold any Southern European government bonds in our bond and balanced funds, although we do have government bonds from a number of emerging markets. As far as corporate bonds are concerned, we tend to prefer stocks from quality companies, rather than bonds issued by companies with more or less high levels of debt on their balance sheets. The only high-yield bonds in the portfolio of BL-Global Flexible are issued by the Mexican company Cemex, the third-largest cement manufacturer in the world after Lafarge and Holcim. The yield to maturity on these bonds, one of which matures in 2014, the other in 2017, is around 10%. Prior to a major acquisition made just before the crisis (Rinker Materials in Australia in 2007), Cemex had the reputation of being one of the best managed companies in Latin America. Following the takeover, which was financed through debt, the company was forced to renegotiate the conditions on its bank loans. Since then, Cemex seems to be back on track again. A significant share of its revenue is generated in the United States. Cemex’s current credit rating is ‘B’, a clear reflection that its loans are certainly not without risk and are not suitable for all investors;
Less classic euro-denominated bonds: Over the last years, some companies have issued perpetual (often subordinated) or very long-dated (100 years) bonds. We hold some of these types of bonds issued by German companies Bayer, Linde and Henkel. These bonds usually pay a fixed coupon for a couple of years after which the coupon becomes a variable coupon based on money market rates, plus a margin of 200-300 basis points (2%-3%). The company usually has the possibility to pay back the bond before maturity at set dates. For example, the Bayer bond was issued in 2005 with a maturity of 2105 and pays an annual coupon of 5% until 2015. From 2015, Bayer has the possibility to pay back 100% of the loan. If it does not pay back the loan, the annual coupon will switch to the 3-year interbank rate plus 280 basis points (2.8%). As is the case with classic bonds, these kinds of bonds can be sold at any time in the market. It is important to note, however, that in periods of strong turbulence (such as in 2008), prices offered for these bonds tend to be heavily penalised (due to their long maturity date) and may no longer accurately reflect the issuing company’s fundamentals. An investor who may have to sell during such a period could suffer a significant loss;
Dividend stocks: many companies are paying a very attractive dividend in light of the low level of interest rates. Some companies’ stocks are even offering a higher return than their bonds. An example is the French company Vivendi. At its current price, Viviendi’s 2014 bond is offering a 2.8% yield to maturity, while the Vivendi stock is offering a net dividend yield of 5.3%. Obviously, stocks are more volatile than bonds – and a company has to pay interest on its debt before paying out dividends. However, for investors unperturbed by such volatility and who are simply looking at the result of their investment in 2014, the Vivendi stock is an attractive alternative to the bond. As in the AUD bond example above, the higher return offered by the stock provides a margin of safety in the event that the Vivendi share price falls. The share price could, therefore, fall 10% from its current level BEFORE the return on the Vivendi stock falls below the return on the Vivendi 2014 bond. Note that the Vivendi share price has already fallen by around 40% in the past three years.

Vivendi’s share price performance over 5 years

In conclusion, the suggestions above come with a (much) higher volatility than traditional fixed income investments. This is the price to pay for a higher return. However, this should not constitute a major issue for investors with a long-term investment horizon.

Some thoughts for the summer (3): Fiscal prudence versus economic slowdown

2010-09-03T11:58:49+02:00

The economic statistics published in the last few weeks show that economic activity in the leading industrialised countries is starting to slow down again. A slowdown that is hardly surprising: I’ve written on numerous occasions about the artificiality of the economic upturn of the last twelve months since it was induced by public spending. The fundamentals for a sustainable recovery were not in place given a debt-laden private sector and the fragility of the banking sector. What was surprising in the last 12 months was not the strength of the economic recovery but its weakness, when we consider the resources deployed – interest rates at historic lows and budgetary deficits at record levels for peacetime.

The renewed economic slowdown comes at a particularly delicate time. To combat the banking crisis and counter the negative impact on growth resulting from the deleveraging underway in the private sector (especially Anglo-Saxon households and banks), the authorities have accepted an unprecedented increase in their own debt, witness the massive increase in the public debt-to-GDP ratio in all countries and the explosion of the balance sheets of the central banks which have been forced to increase the monetary base to buy up dubious-quality notes held by the banks. The objective was that once the economic recovery was sustainably on track and the situation “back to normal”, governments would start to reduce their budgetary deficit and the central banks would start to unwind the exceptional measures they had put in place during the crisis.

A new slowdown in the economic situation, or even a recession, would put this objective in danger. The United States would have to take action just when unemployment rates are hovering around 10%, short-term interest rates are close to zero and the budgetary deficit is more than 10% of GDP. Before the publication of the recent very bad statistics on unemployment and the real estate market, a debate had already started between those calling for a rapid return to budgetary rigour and those coming down on the side of not rushing into any such return for fear of risking a headlong dive back into recession. The latter have been vindicated by the latest economic figures and are calling for further budgetary stimulus measures.

However, a government cannot go on racking up debt endlessly. In their book “This time is different” (1), the American professors Reinhart and Rogoff show that it is nevertheless impossible to determine a precise level of debt (in absolute value or as a percentage of GDP) that would trigger a crisis or payment default. The Russian crisis in the 1990s came at a time when the country’s debt-to-GDP ratio was only 12%, while Japan’s public debt is currently over 200% of GDP without a crisis. It all depends on investors’ confidence in the country, the presence of domestic investors, the percentage of public debt denominated in foreign currencies, the reasons at the source of the public sector debt (productive investments that increase the country’s growth potential – and therefore its capacity to honour its debt – or cash for clunkers?), and the capacity of the political authorities to impose public spending cuts or a tax hike.

That said, there are several elements that make the current situation particularly dangerous. The deterioration of public finances is now a widespread phenomenon in the industrialised countries. The examples often cited of heavily-indebted countries that have succeeded in re-establishing their budgetary situation and reducing their debt, such as Canada, Finland or Sweden in the 1990s, are a bit deceptive since at the time, these countries were the exception and not the rule and they were able to profit from robust world growth and the depreciation of their currency to enhance their fiscal receipts. Secondly, countries now have to bear the burden of a welfare state that is becoming ever more onerous with the ageing population and increased life expectancy. Current debt-to-GDP ratios, high as they are, do not take into account a number of commitments made by governments to their citizens, especially as regards pensions and health insurance. And lastly, notwithstanding historically low interest rates, debt servicing is starting to swallow up a growing proportion of government receipts. Without enormous political courage and substantial sacrifices by the population not to mortgage the future for generations to come, it will therefore be extremely difficult to reduce public spending in any meaningful way. The worry must thus be that a potential return to budgetary rigour will entail an increase in taxes despite numerous academic studies that show the negative multiplier of a tax rise on the economy. In other words, a tax rise reduces the potential for medium and long-term growth. The multiplier of a tax hike is often estimated at between -1 and -3, meaning that a 1 billion tax rise will have a contractionary impact on GDP of 1 to 3 billion over 10 years. However, to reduce the public debt-to-GDP ratio, it is vital not to ignore the ratio’s denominator, i.e. the growth aspect. To avoid a catastrophic scenario, the growth rate of GDP must exceed the interest paid on the debt. A return to budgetary rigour should then be achieved by measures that will not penalize the long-term growth potential of an economy. In their book, Reinhart and Rogoff show that cuts in public spending are preferable to higher taxes when it is a question of re-establishing the economic health of a country after a financial crisis. This is particularly the case for Europe where public expenditure already represents a significant proportion of GDP, to the detriment of the private sector.

Highest Marginal Income Tax Rate in the United States between 1925 and 1940

Source: Gluskin Sheff

So what are the consequences for the financial markets?
First of all, we are in an exceptional situation and investors should stop basing their investment strategy on what has traditionally happened in a classic cycle. Second, interest rates will remain low, partly because of structural elements weighing on growth and the risk of deflation, and partly because the authorities will do their utmost to prevent a rise in interest rates given the disastrous effect that such a rise would have on debt servicing. Hence the recent emergence of the term “financial oppression” – forcing creditors to accept a real return that is artificially low, or even negative (by, for example, encouraging the banks to massively buy government bonds). But the low level of interest rates is not a good enough reason to buy risk assets with unrealistic return expectations. As the Financial Times said recently: “The only thing worse than a low-yielding world is denying that it exists.” Unlike the bond market, so far the equity market has not factored in the new economic reality of lower growth. And lastly, as regards government borrowing, we are bound to conclude that some countries are now in a situation where the only logical outcome is debt restructuring. In general, these are countries that do not have control over their currency, where the low level of interest rates has led to over-consumption and speculative bubbles, and where a significant portion of their debt is held by foreigners. For other countries, creating inflation to reduce the real cost of debt could be tempting but we haven’t quite got to that point yet. Especially as a significant proportion of public expenditure is now indexed to inflation.

(1) Carmen Reinhart, Kenneth Rogoff: This time is different - Eight Centuries of Financial Folly, Princeton University Press.

Some thoughts for the summer (2):
Interpreting the increase in the price of gold

2010-07-26T14:42:34+02:00

2009 was a good year for gold investors. The gold price increased by 24% in USD and by 21% in EUR. So far in 2010, this positive performance has continued in 2010 with the gold price gaining a further 13% in USD and 32% in EUR. Such gains raise the question of whether gold has entered overbought territory and whether a price bubble is forming.

I have often said that it is hard to regard gold as anything other than speculation: its economic applications are limited and it does not generate any form of cash flow. Its lack of intrinsic value makes it impossible to put a price on it, at least by conventional yardsticks. It only derives value from the fact that others find it valuable. The only way to make money with gold is to find someone else willing to pay an even higher price. To quote Warren Buffett: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

That said, there have been periods in history when buying gold has produced outstanding results. Between 1976 and 1980, the price of gold quintupled and in the last 10 years, it has gone from 300$ to 1200$. It is therefore interesting to look at the catalysts that favour higher gold prices.

Gold Price since 2000 (in USD)

Gold basically goes up when people lose faith in paper money. Broadly speaking, this is the case when they perceive that there is a high risk of rising inflation or when solvency risk escalates, i.e. when people fear that their bank is no longer trustworthy or that governments will no longer be able to repay their debt. Both these risks are prevalent in the current environment given the dangerously high levels of government debt. Gold is the currency of fear. It acts as a gauge for the health of the financial and monetary system.

It is important to note that given the small size of the gold market, it only takes a small number of investors to buy gold for the gold price to go up. The total amount of gold available for investment purposes (i.e. excluding jewellery and industrial applications as well as central bank reserves) represents about 0.5% of total global financial assets. Even a small increase in demand for investment purposes represents an amount of gold that cannot be met by mining or recycling, at least not in the short-term. According to the Canadian research firm, the Bank Credit Analyst, a one percentage point increase in the share of gold in investors’ portfolios would be consistent with a tripling in gold prices from current levels.

Apart from rising inflation and solvency risk, two other factors are supporting the gold price.

On the demand side, there is the emergence of Asia where gold has greater significance than in the western world. Last November, India agreed to purchase 200 tons of gold from the IMF. China will have to continue buying gold if it wants to maintain its current share in terms of total reserves. If China decided to bring that share back to the level of 10 years ago (China’s reserves have grown so rapidly over the last decade that the share of gold in its total reserves has fallen), this would significantly boost the demand for gold. Central banks of other emerging countries also seem prepared to buy gold at market prices in order to diversify their reserves.

On the supply side, output from gold mines peaked in 2001 at 2,600 tons and has been drifting down since then, especially in the traditional producer countries (Australia, Canada, South Africa and the USA). This decline cannot be easily reversed. Peter Munk, the founder of Barrick Gold, has recently said that nobody realizes how serious the supply situation is, with large deposits nearing the end of their useful lives while new production is becoming ever more difficult and expensive.

Because it is impossible to value gold using conventional metrics, analysts often look at the long-term relationship of gold with others assets or with economic variables. These include:

- the ratio of the gold price to the stock market. The ‘Gold/Dow Jones Industrial Index’ was 1 in 1980, the end of the last bull market in gold (Gold price: 850$, DJII: 850), fell to 0.025 in 1990 (Gold: 290$, DJII: 11,500) and has since risen again to 0.12 (Gold: 1200$, DJII: 10200). Some people think that this ratio could go back up to 1 again with the equity market losing half of its value and the gold price rising to 5000$ an ounce. It is important to note, however, that if one excludes the extremes, the ratio of gold to the stock market is currently more or less at its long-term median;

- the ratio of gold to oil. In 1973, one ounce of gold would have bought 42 barrels of oil. In July of 2008, one ounce of gold would have bought six barrels of oil. The current ratio of gold to oil is close to its long-term median;

- the ratio of gold to GDP. In 1980, the market value of the above-ground stock of gold relative to global GDP peaked at 25%. It fell to below 3% in 2002 and currently stands at 8%. Again it is important to bear in mind that 1980 and 2002 were extremes. If we compare the gold price to G7 per capita income, for example, we will find that this income is currently equivalent to about 40 ounces of gold whereas over the past 40 years, it has been equivalent on average to 60 ounces.

Finally, though gold has recently hit new highs in nominal terms, it is still nearly 50% below its 1980 peak in real terms, i.e. adjusted for inflation. To bring it back to that peak in real terms, a nominal price of 2,300$ per ounce would be needed. In this respect, it is interesting to see that commodities typically set new all-time highs on an inflation-adjusted basis during bull markets.

An investor looking to buy gold should however be aware that the gold price has now become highly dependent on continued investor interest. One of the properties that make gold attractive as a store of value - the fact that it is virtually indestructible – is also its weakness. Almost all of the gold ever mined is still in circulation today. Thus, even with stagnating or declining mining output, the amount of gold that could potentially come to the market is huge. According to the World Gold Council, a total of 11,125 tons of new gold supply entered the market between 2007 and 2009. This consisted of 6,402 tons from mines (gold production), 757 tons from central bank sales and 3,966 tons from the recycling of old jewellery into new gold products. During that time, only 7,646 tons were bought for the purpose of creating jewellery or for industrial and dental applications. The remainder was purchased for investment purposes. In 2009, investment demand thus accounted for nearly 40% of total demand, compared to 5% in 2000. The potential mismatch between supply and demand is even increasing given that jewellery and industrial demand is proving price-sensitive and is therefore declining because of the increase in the gold price (jewellery demand has fallen by nearly 30% between 2007 and 2009, industrial demand by 20%). There is also the possibility of some countries selling part of their gold holdings in order to consolidate their budgets. However, the fact that the Central Bank Gold Agreement, which stipulates that a maximum of 400 tons of gold per year can be sold by the central banks of the main industrialized countries, was renewed in August of 2009 for a period of five years should limit that risk. Finally, de-hedging of gold producers seems to be coming to an end (de-hedging reduces total mine supply).

To conclude, I do not think that a “gold bubble” is forming, similar to what happened (with hindsight) in 1980. Back then, the gold price increased by 80% in one month, fell back again, before going into 20 years of hibernation. By contrast, even though gold has risen a lot over the last years, there have been regular corrections of more than 10% and there has never been a parabolic increase in the price. This type of behavior is much more typical of a bull market than a bubble.

Gold Price between 1976 and 2000 (in USD)

Whether one thinks that this bull market is coming to an end or is still at an early stage depends on one’s view on the economic and financial situation. I started by saying that gold only derives value from the fact that others find it valuable. However, the same can be said about paper money. The integrity of paper money is now being questioned with more and more people fearing its implicit (inflation) or explicit (depreciation, currency reform) debasement. If the worst of the crisis is behind us, these fears should abate and investors’ interest in gold should wane. Otherwise, the future for gold remains bright.

Presentation BL-Global Flexible

2010-07-26T14:40:52+02:00

To download a presentation of the general characteristics of BL-Global Flexible and of its portfolio as at mid-July, please click on the following link.

Banque de Luxembourg Bl Global Flexible

Some thoughts for the summer (1): Could stock markets return to their early 2009 levels?

2010-07-22T13:58:44+02:00

Summer is a good time to take a step back from the daily fluctuations on the financial markets and think about trends that could affect the financial environment in the next few years. The exercise makes even more sense this year, as the markets seem to be mainly driven by technical considerations while they wait for fundamentals to gain the upper hand.

It seems impossible today that the stock markets could return to their early 2009 levels, or even fall further, just as in October 2007, it seemed impossible that the markets could slump 60% over 18 months, or in March 2009, that they could shoot up by 70% in the space of one year. Investors tend to base their strategies and return expectations on their recent experience. At the start of the 1980s, after 15 years of virtual stagnation in share prices coupled with significant volatility, people were not interested in stocks. On the cover of its August 1979 edition, BusinessWeek magazine proclaimed the “death of equities” (‘The Death of Equities. How inflation is destroying the stock market’). Twenty years later, the Dow Jones had risen to 11,500 from 840 and investors’ faith in the markets was such that equities were considered by far the best long-term investment.

One interesting aspect is that despite a very bad decade for the stock markets during which they strongly underperformed the money and bond markets, the cult of equities still seems to be thriving. Given that the slightest technical rebound sends investors shooting back to the markets, equities have never really corrected their massive overvaluation of the end of the 1990s and remain at much higher valuations than those that led to the great bull markets of the past. At the start of the 1980s, US stocks were trading at six times earnings and paying an average dividend of 6%. Today, despite 10 years 'for nothing’, they are still two to three times more expensive. Some attribute higher equity valuations to the current low interest rates. As well as diminishing the attraction of the main alternatives to equities (cash and bonds), low interest rates also increase the present value of a company’s future earnings (earnings of €1 million in 2020 have a present value of €386,000 when discounted at a rate of 10% and of €614,000 when discounted at 5%) However, the low interest rate argument does not detract from ‘the price paid determines the return’ principle, nor does it alter the fact that when equities are bought at 20 times earnings, we should not expect the same return as if we paid 10 times those earnings. In other words, saying that equity valuations are attractive because of the low level of interest rates is tantamount to saying that equity returns should be higher than those of fixed-income investments in the coming years. Empirical studies show that an investor buying the US market at its current valuation in the past would have on average obtained a real annual (inflation-adjusted) return of around 3% in the following 10 years. 3% is indeed better than the return to be expected from a money-market or bond investment: the average yield on a German Bund or US Treasury bond is currently around 2.5% (to reach a real return of 3%, there would thus have to be annual deflation of 0.5%). Nevertheless, 3% seems to me to be well below the figure investors have in mind when they buy stocks.

Using the argument of low interest rates to justify investing in stocks also seems rather audacious when the low level of interest rates is due to an extremely fragile economic and financial environment, as is currently the case. The decline in interest rates and the rise in valuations in the 1980s and 1990s was due to falling inflation and improving economic fundamentals. Today, these fundamentals are deteriorating and interest rates cannot fall a lot further. This is hardly an ideal environment for valuation multiples to rise. One often reads that stock markets have corrected their valuation excesses and that multiples are reasonable (in the case of the United States) or even cheap (in the case of Europe). The argument being that, based on the most commonly-used equity valuation measure, the Price/Earnings ratio (PE), the markets are trading today at lower multiples than the historical average. This prompts two observations. First, this argument is only true if the denominator used in the PE ratio is 12-month forward earnings estimates. In the past such estimates tended to be far too optimistic. Moreover, they exclude non-recurring charges. The next point is that while the average long-term PE ratio is around 15, the reality is that equities rarely trade at 15 times earnings. In practice, periods during which stocks are more expensive (PE above 15) tend to alternate with less expensive periods (PE below 15). In other words, the idea of "mean reversion" implies that when markets have been overvalued for a long period (as was the case throughout most of the past 20 years), they have to 'pay the price’ in the following years by trading at below-average multiples. Take a company with earnings per share of $1 and trading at 20 times earnings (PE of 20), i.e. $20. If, five years later, its earnings per share have risen by 50% (to $1.5) but the market is only willing to pay 10 times earnings, the share price will be $15 (a fall of 25% in value).

It is possible that we will see this kind of multiple compression in the coming years. The fall in interest rates that resulted in higher multiples in the 1980s and 1990s has practically run its course. Inflation is close to zero and could soon turn into deflation (unlike falling inflation, deflation is bad news for the stock markets. History shows that once inflation drops below 1%, valuation multiples fall). The economic recovery remains very fragile: the high level of debt and the deterioration in public finances are weighing on growth in the industrialised countries. The fact that the problem is mainly on the demand side increases the deflation risk even further, especially given that although governments have managed to offset the weakness in economic activity in the private sector by increasing public spending, this may no longer be an option given the scale of budget deficits. If the economy slows again and falls into recession, there will come a time when the authorities will have no ammunition left to kick-start growth.

I think that if current ranges (~1000-1200 for S&P500, ~225-275 for DJ Stoxx 600) can hold for a little longer, the next significant move on the stock markets will be down. Traditional economic indicators (such as employment and retail sales) clearly show that the United States is not experiencing a classic recovery. As well as this, the positive impact of stimulus measures are starting to wane, the housing market is starting to decline again and recent figures show that there has been a relatively significant slowing in economic activity.

I have written many times that the upside potential for stocks (in the industrialised countries) for the next three to five years seems limited from current levels and that an investment strategy should focus on the ‘return' aspect - i.e. dividends. Of course, buying a stock for an annual dividend of 5% is much less exciting than buying for a quick 20% gain. However, it is interesting to note that the dividend theme is starting to take on increasing importance with both companies (according to Barron's magazine, the ratio of US companies increasing their dividend and those lowering it is currently 9:1) and investors, judging by capital flows that show that the quest for regular returns is rapidly becoming a secular investment theme. Demographic trends should speed up this trend as ageing baby-boomers are less inclined to take risks and tend to be more reliant on regular returns to finance their retirement. From this point of view, the fact that the dividend yield on the S&P 500 is currently around 40% below its historical average is not a good sign for the market overall.

Analysis of the situation in ten points

2010-06-14T16:31:24+02:00

In the following I have tried to sum up in ten points my analysis of the economic and financial situation.

1. In the past 30 years, the world economy has become very leveraged.

This is due to the declining cost of borrowing (i.e. interest rates), following the success of the monetary authorities in fighting inflation. Debt increased in two waves – the first in the 1980s, followed by consolidation in the 1990s, and a second wave which has been underway since 2000. It is the second wave of debt that has undermined the economy, initiated by the Federal Reserve’s irresponsible monetary policy in the wake of the bursting of the technology bubble. By maintaining its key interest rate at an artificially low level, the US central bank encouraged recourse to debt (consumer credit rose every month between February, 1998 and July, 2008) which notably gave rise to a real-estate bubble and the multiplication of activities having no economic added value. Other phenomena, such as the deregulation of finance, have intensified this trend. Debt levels are now very high by historical standards.

2. Two important economic players - US households and banks - have embarked on a process of deleveraging.

Just as the process of leveraging up boosted growth (borrowing money to buy a car stimulates consumption), the process of deleveraging will weigh on growth (the money used to pay back a loan cannot be spent on other things). The problems experienced by US households mean that the growth model of the past three decades – world economy driven by the United States, US economy driven by private consumption, private consumption driven by recourse to debt – is now a thing of the past. The influence of the US consumer has been even greater because the growth model of other countries or regions is often primarily based on exports rather than internal demand. Whereas in the 1970s, the world was in a situation of excess demand, today we have a situation of excess supply (which also explains why the current environment is characterised by deflationary pressure - in the 1970s, it was marked by inflationary pressure). In this situation, the US consumer was to some extent ‘the consumer of last resort’. From the beginning of 1992 to the end of 2007, there was an unprecedented 64-quarters uninterrupted string of rising consumer spending.

3. To make up for the deleveraging in the private sector, the public sector has opted to get into debt.

Over the past two years, we have seen an unprecedented increase in the level of government debt. This is due to the governments' desire to save the banks and launch stimulus measures to offset the weakness in the private economy. The situation is even more concerning in light of the fact that in many countries, demographic trends will increase pressure on public spending in coming years. Also, a big percentage of government debt in a lot of countries will have to be refinanced within the next three years.

4. The very high public sector debt levels are undermining the economy and bringing about new risks.

In their book, ‘This Time is Different’, economists Carmen Reinhart and Kenneth Rogoff note that history has shown that once the public debt to Gross Domestic Product ratio approaches 100%, economic growth slows and there is greater risk of sovereign default and/or galloping inflation as well as of a systemic crisis. Added to this is the prospect of social tensions linked to the end of the Welfare State model based on using debt to finance untenable electoral promises.

5. The high level of debt is a problem in the industrialised countries but not in the developing countries.

In most developing countries, the degree of debt is low at all levels of the economy - households, businesses and governments alike. This means that the next public debt crisis will not occur in these countries, contrary to what we had got used to seeing in the period 1980 and 2000, with the Latin American and Asian crises.

6. The European and US authorities will maintain their interest rates at very low levels for a long time.

In an environment characterised by high levels of debt, weak economic growth and fiscal austerity, the European Central Bank and the US Federal Reserve will wait a long time before tightening their monetary policy. Given that the return on a money-market investment is directly linked to the central bank rates, the yield on a ‘no-risk’ investment will remain very low in the coming years. ‘Doing nothing’ is therefore also a decision and the opportunity cost of such a decision is high in a context of short-term rates close to zero.

In the longer term, the main challenge for the European and US monetary authorities will be to uphold a highly accommodating monetary policy without giving the bond markets the impression that they are abandoning their inflation control target. If this were to happen, medium- to long-term interest rates (over which the authorities have no direct control) would increase with disastrous consequences for public finances in a number of countries.

7. The myth of the ‘no-risk’ government bond is being put to the test and investors will increasingly differentiate between countries.

One year ago, the yield on the 10-year German government bond was 3.7%, while Greek bonds were offering 5.5%. Today, the yield is 2.6% and 8.1% respectively. Investors have cast doubt on the ability of Greece to honour its debt and the country has entered into a vicious circle in which the rise in medium and long-term interest rates pushes up the cost of servicing its debt, which accordingly increases the risk of restructuring and in turn justifies a further rise in the level of interest rates. In contrast, Germany is benefiting from a 'flight to quality' and finds itself in a virtuous circle. The diverging developments in the cost of financing in the two countries further widen their competitive divide, born out of the diverging developments in unit labour costs. If we generalise a little, we could say that what is true for Germany is true for northern Europe, while Greece is representative of southern Europe. The competitive gap between these two regions will result in increased pressure on the euro. The single currency’s survival in its current form is dependent on a massive solidarity effort between the European countries and unprecedented fiscal austerity in some countries. Fiscal austerity will however weigh on these countries' economic growth and they risk loosing on the tax revenue side much of what they save on the spending side.

Apart from a few exceptions, bonds issued by the governments of the industrialised countries are no longer attractive. Either they offer a very low yield, or they involve a more or less significant risk of payment default (not to mention the risk, to which some are alluding, that the increase in public debt will result in significant inflation through recourse to the printing press). Government bonds issued by the emerging countries are enjoying better fundamentals but yields on these bonds have already fallen a lot and selection will have to be made on a case-by-case basis. The same is also true for corporate bonds.

8. The traditional distinction between high-risk assets (= equities) and low-risk assets (= government bonds) makes less and less sense in the current environment.

This distinction exists because investors are used to associating risk with volatility. While share prices are known to rise and fall by 10% or more in a short space of time, this kind of variation is less common in government bonds and practically non-existent in money-market investments, which, in principle, can only rise in value unless there are negative short-term interest rates. In the current context, we could nevertheless also consider that the risk of an investment is that investors will not receive their coupon, will not get their money back, or will see the value of their investment significantly diminished by inflation.

In comparison with government bonds, equities currently offer two major advantages. First, unlike what is happening at government level, many companies are in excellent financial health. Second, equities represent real assets and for this reason offer, in theory at least, better protection against inflation.These risks should certainly no longer be ruled out and affect particularly fixed-income investments.

The fact that money-market rates are so low is obviously another factor that could boost the equity markets. I have often said that low interest rates are not a good enough reason for buying stocks - particularly when, as is the case now, low rates are the result of an extremely fragile economic situation. However, the fact remains that when interest rates are low, investors are more eager to buy stocks.

9. There is little upside potential for the US and European stock markets from current levels over a three to five year horizon.

This conclusion may be surprising coming after a particularly bad decade for the stock markets of these regions, with most indices today some 25% below their end-1999 level (excluding dividends). Under normal circumstances, one would expect that after such a disappointing performance, US and European equities would be cheap and ‘ripe’ for a new structural bull market (just as the poor performance of the markets between 1966 and 1982 gave rise to the bull market of 1982 to 2000). But this is not the case. The poor performance of the US and European markets in the past 10 years is due to equity valuations reaching extremely high levels at the start of 2000. Since then, multiples have become more reasonable. However, they are still much higher than those that in the past marked the beginning of the major bull markets, especially in light of the fact that the phenomenon which pushed up valuation multiples in the 1980s and 1990s - the decline in interest rates - has now more or less run its course.

The stock markets of the industrialised countries are therefore expected to remain volatile characterised by bull and bear cycles similar to what we have seen in the past 10 years. However, they are not likely to be much higher 5 years from now (and may even be much lower). The conclusion is that a passive buy-and-hold strategy will produce disappointing results and that an active strategy is much more appropriate in the current environment. One aspect of an active strategy is stock-picking. We give priority to quality companies (low levels of debt, high return on equity), which are strongly exposed to regions with higher growth potential and are able to pay attractive dividends to their shareholders. The (justified) premium that the market usually grants to such companies has now disappeared since they significantly underperformed during the stock market recovery in 2009.

10. The emerging markets are in a structural bull cycle.

In simplified terms, we could say that whereas the 20th century belonged to the United States, the 21st century will be Asia’s. The stock markets have begun to realise this and in the past few years, the developing markets performed much better than the industrialised markets. The trend is set to continue in light of the good fundamentals in the developing countries.

An investor should however be aware of the fact that the emerging markets will remain volatile, continuing the trend of the past few years. This is mainly due to the dependence of the emerging countries on Europe and the United States - economically dependent as they wait for internal demand to grow, and financially dependent as their financial markets remain strongly influenced by foreign capital.

BL-Global Flexible – Update 18 May 2010

2010-05-21T16:29:53+02:00

On 18 May, the net equity allocation was 36%. BL-Global Flexible held 79% of its assets in equities, of which 43% were hedged through the sale of futures. Using derivatives to achieve a net equity allocation of 36% provides two advantages over a more traditional solution of ‘simply’ holding 36% in equities:

- It prevents us from having to invest 64% in fixed income assets, which currently offer less and less interest;

- It allows us to take advantage of the fact that after having strongly underperformed in the 2009 stock market recovery, quality companies (which we like to own) are currently trading at attractive levels to the overall market.

The good performance of the bond markets was used to gradually reduce our allocation to bonds to 17% of the portfolio.

Asset allocation

(1) of which 43% is covered through the sale of futures

Including currency hedging, BL-Global Flexible is currently invested 43% in euro and 57% in other currencies:

Currency allocation (after possible forward exchange contracts)

The graph below compares the performance of BL-Global Flexible with a money-market investment in euro, an investment in eurozone government bonds (represented by the JPM Bond index) and an investment in international equities (represented by the MSCI World index in euro). Given that the objective of BL-Global Flexible is to provide traditional wealth management, it is in my opinion logical to compare its performance with the performances of the asset classes used in this portfolio (money-market investments, bonds and equities) rather than a specific index.

To the extent that the volatility on the stock markets rose once again in 2010, it is interesting to compare the performance of BL-Global Flexible with the MSCI World index (international equities) in the first months of this year. The following graph shows that the fund held up well during the corrections in January/February and April/May.

Finally, it is useful to note that with its current structure, BL-Global Flexible is likely to perform well in an environment in which quality companies are outperforming the market (either because their price is rising more than the market, or because it is falling less than the market). I think that the conditions are right for this to happen given that:

- As noted above, quality companies underperformed in the market recovery between March 2009 and the start of 2010, and are today correctly valued in absolute terms and attractively valued in relative terms (i.e. compared to the market overall).

- After the second half of 2009, which was marked by expectations of economic recovery and the end to the financial crisis (which was particularly good for cyclical and financial stocks), events in the past few weeks have shown that the economic situation remains very fragile. In such an environment, a flight to quality by investors would make sense.

Worrying deterioration in public finances in the industrialised countries

2010-04-12T14:52:01+02:00

There has been much coverage of the economic problems of Greece in the past few weeks. However, Greece is not an isolated case, even if there are a number of factors at play that makes the country’s situation particularly dangerous. On the contrary, what is happening in Greece reflects a development that investors should take very seriously and that could have a significant impact on the behaviour of the financial markets in the coming years, namely the massive deterioration in public finances. This development calls for some comments.

- Government debt is at an historically high level (at least during peace times). This situation is especially worrying in light of the fact that in many countries, the ageing of the population will further increase pressure on public spending in coming years (unless there is a change in the pension systems);

- The government debt problem is particularly worrying in the industrialised countries. Developing countries are in a much more comfortable situation.

- Most of the industrialised countries are affected. In the 1990s, countries like Canada, Finland and Sweden experienced serious problems in their public finances – today the problem is widespread. According to Willem Buiter, chief economist at Citibank, more than 40% of world GDP is generated by countries where the budget deficit currently exceeds 10% of GDP. (It is worth highlighting the fact that Canada, Finland and Sweden have managed to resolve their problem by cutting public spending and today are amongst the least indebted countries in the world);

- In many countries, the high level of debt in the public sector is coinciding with a high level of debt in the private sector. As the economists Carmen Reinhart and Kenneth Rogoff say in their book, "This time is different"⁽¹⁾, when assessing a country’s outlook, it is total debt that must be taken into consideration. In many countries, total debt has reached a level that, in the past, has led to crises, defaults or inflation.

It is still too early to know how this high level of public debt will impact financial markets exactly, especially since much will depend on the measures taken by the authorities and the speed of implementation of such measures. However, a number of conclusions can already be sketched out:

- The high level of debt will weigh on growth. In their book, Reinhart and Rogoff say that once a country’s public debt exceeds 90% of GDP, its growth rate shrinks by around 1%. Now the International Monetary Fund states that by 2014, public debt will exceed 100% of GDP in the United States, the United Kingdom and the eurozone. The easiest way to cut the debt ratio (public debt / GDP) – have the denominator increase faster than the numerator, in other words, through robust economic growth – seems to be less and less of an option for these regions;

- Unless they react quickly, some countries could even enter a vicious circle, similar to what is happening right now in Greece. Loss of investor confidence in their ability to honour their debt could lead to a rise in medium- to long-term interest rates (over which the monetary authorities have no direct control) in these countries. Servicing the debt would then become very costly. In many industrialised countries, more than 10% of public revenues already go to servicing the debt, despite the current low level of interest rates. If rates rise, a more significant share of public income would have to be used to service existing debt (which would make cutting public spending even more painful);

- From the above, it also follows that the theory whereby it will be increasingly tempting for governments to resolve their debt problems through inflation is too simplistic. The bond markets are very aware of this risk and would penalise any sign of a return to printing money by driving up long-term interest rates. Moreover, in many countries, a high percentage of public spending is directly or indirectly linked to inflation;

- Reinhart and Rogroff suggest that the authorities could however try to maintain a low level of long-term interest rates by obliging financial institutions to buy government bonds through, for example, new prudential measures imposed within the framework of a re-regulation of the financial system. By creating a forced demand for their bonds, they could make it easier for themselves to refinance their debt;

- The book by Reinhart and Rogroff also shows that seeing governments default on their debt is nothing extraordinary from an historical point of view, and that it is more the lack of such defaults in the past few years that should astonish;

- The bond markets should, in light of this, make a greater distinction between countries and penalise those countries whose public finances are regarded as being unsustainable. Canadian research provider BCA Research recently analysed 22 industrialised countries using criteria such as economic structure, monetary and fiscal flexibility, debt burden and dependence on foreign capital. According to their criteria, seven of the soundest countries are Norway, Switzerland (which is nevertheless running the potential risk of having to recapitalise its banks), Sweden, Finland, Austria, Canada and New Zealand. At the other extreme, we find UK, Italy, Spain, Ireland, Portugal, Greece and Iceland;

- It may also be likely that in the future, certain high-quality corporate bonds could become less risky than their home countries and that the distinction between 'government bonds' and 'corporate bonds' would lose much of its importance;

- A low-growth environment, high levels of public debt, a latent risk of deflation or inflation, or a payment default is at first sight not favourable for the stock markets. It should be pointed out, however, that compared to consumers and governments, the financial health of many companies is in good shape. With money-market rates close to zero, these companies could return to favour with investors and even start to play a role of safe haven. The investment themes of ‘quality companies’ and ‘dividends’ should therefore not be overlooked;

- Finally, from the above, the conclusion is that an increasing part of an investment portfolio should be oriented towards Asia and the developing countries which have much lower debt levels and a much higher growth potential.

⁽¹⁾ Carmen M. Reinhart, Kenneth S. Rogoff: This Time is Different – Eight Centuries of Financial Folly (Ed. Princeton University Press)

The economic situation in Greece – continued

2010-03-31T11:23:57+02:00

The rescue package adopted last week by the members of the eurozone could temporarily help Greece refinance itself in acceptable conditions in the coming months. However, the package has not changed the fundamental situation:

- The other eurozone countries are in a too fragile state to be able to provide any real sustainable assistance to Greece, particularly taking into account their massively unfunded pension liabilities;

- Lending to Greece might enable the country to face up to its short-term liquidity problems but will not resolve its solvency problem. Greece has entered a vicious circle in which its public debt to gross domestic product ratio has exceeded 100%, and in which interest paid on the debt is higher than the rate of nominal GDP growth (in other words, the numerator of the ratio is increasing faster than the denominator);

- Debt is not Greece’s only problem. It has a fundamental problem of competitiveness due to the sharp increase in labour costs (adjusted for productivity gains) in the past few years. Its lack of competitiveness is reflected in the very high current account deficit, making it strongly dependent on foreign capital. Once foreign investor confidence has been shaken, this dependence makes a country extremely vulnerable;

- Greece cannot devalue its currency, which means that restoring its competitiveness will only be possible through a downward adjustment in wages (unless productivity suddenly soars), a much more painful and politically-challenging solution. It could be that the increasing awareness within the country is such that it may be possible to impose the necessary measures (similar to what seems to be the case in Ireland). Nothing could be less sure, however, especially since the very low level of inflation in the eurozone means that Greek wages will just have to fall, rather than simply increase less than wages in other countries;

- The problems of debt, budget deficits and lack of competitiveness (and therefore external debt) are all linked. The accounting identity whereby "private sector financial balance + public sector financial balance - current account balance = 0" means that a reduction in the debt of the Greek private and public sectors will not be possible unless the country records a current account surplus (the current account balance is recording a deficit of around 9 % of GDP). The only scenario in which Greece could quickly experience a surplus in its external trade balance would be if its imports collapsed following a very severe economic recession and a deflationary environment;

- Greece is not the only country to be experiencing a lack of competitiveness. Broadly speaking, Southern Europe is no longer competitive compared to Northern Europe (which seems to explain the recent criticisms of Germany’s trade surpluses). The Southern European countries will not be able to restore their competitiveness by devaluing their currency given that they are in the euro⁽¹⁾. This situation will generate increasing pressure on the monetary union and single currency. It is worth noting that many economists had brought up this risk when the single currency was introduced, but at the time, any criticism of the euro was seen as ‘anti-European’. History shows, however, that it is dangerous to ignore economic laws (and common sense).

For the financial markets, two conclusions can be drawn from the preceding:

- The European Central Bank is expected to maintain a very expansionary monetary policy, especially since the budget austerity measures in an increasing number of European countries will restrict the eurozone’s growth potential even further;

- The convergence of bond yields in the eurozone towards the level of the most solid country (and therefore the lowest level), which characterised the period from 1995 to 2008, is over. If the eurozone countries rally around Southern Europe, the financial problems of the latter will spread to Northern Europe and bond yields will converge to an average level that will be higher than that currently prevalent in Germany or the Netherlands. If they decide not to rally, bond yields will diverge and the yield differential between the Northern and Southern European countries will widen.

⁽¹⁾ an alternative would involve a sharp depreciation in the value of the euro compared to other currencies, which would help to restore the competitiveness of the Southern European countries, if not in comparison to Germany, at least compared to the rest of the world. Rather than worrying about the euro’s weakness (which is actually relative as, since launch, the currency has been valued at between 0.85 and 1.60 USD. At the current level of 1.34 USD, the euro is still overvalued), the European authorities should thus encourage a lower euro. The problem is, however, that in the current environment, none of the main industralised countries has any interest in having a strong currency. The Obama administration’s recently-announced National Export Initiative, whose stated goal is to double U.S. exports by 2015, is thus hardly compatible with a strong dollar.

Two anniversaries

2010-03-12T11:59:12+01:00

This week marks the first anniversary of the end of the most recent bear market. Between October 2007 and March 2009, the stock markets lost around 54% (using the MSCI World index in euro as a benchmark) before gaining 62% since then. (Mathematical calculations being what they are, an increase of 62% after a slump of 54% means that the markets are still well below their October 2007 level).

There is another anniversary in March, namely the tenth anniversary of the end of the last structural bull market. Between August 1982 and March 2000, the Standard&Poor’s 500 index rose from 102 to 1527, an annualised return of just under 17%. Yesterday, it closed at 1150, which is 25% below its level 10 years ago. During this period, the index went through four cycles:

- a bear cycle: - 49% between March 2000 and October 2002;

- a bull cycle: + 100% between October 2002 and October 2007;

- a bear cycle: -57% between October 2007 and March 2009;

- a bull cycle: +68% since March 2009.

The situation looks rather similar for most other industrialised stock markets (the emerging stock markets are mostly above their level of 10 years ago).

The poor performance of equities over the past ten years is not surprising given that at the end of the last century, the stock markets had risen to historically overvalued levels. A commonly-used tool for valuing equities is the price/earnings ratio (PE). A PE of 15 simply indicates that investors are willing to pay 15 times the earnings of a company (in other words, investors would pay 15 million for a company generating annual earnings of 1 million). A more sophisticated variant of the price/earnings ratio is the Shiller PE (after Yale professor Robert Shiller) which, instead of using the earnings of the past year or earnings forecasts for the year under way as denominator, takes average earnings over the past 10 years. The idea is to smooth out earnings over a longer cycle to avoid taking a particularly bad or good year. The very long-term average for the Shiller PE is 16. At the start of 2000, the ratio was 40; it currently stands at around 20. Despite the market's poor performance over the past 10 years, the only time equities were undervalued during this entire period (i.e. in Shiller terms, below its historical average of 16) was for a few months at the end of 2008 / start of 2009.

In light of the above, the idea that equities are cheap after their poor performance of the last 10 years is quite simply not true. After the rally of the past 12 months, equities are once again overvalued and their upside potential for the next three to five years seems very limited from current levels. We could of course argue that the low level of interest rates justifies higher equity valuations and that the history of the stock market shows that equities can remain overvalued for very long time periods. I would be more likely to defend the opposite position, according to which the low level of interest rates reflects the very worrying state of the economy and that argues in favour of below-average equity valuations.

It is customary to say that the stock market anticipates economic recovery and that prices often rise before the economic situation improves. This is true, but the fact of the matter is that since March 2009, the US market has risen by around 70% while the US economy has lost more than 3 million jobs. This kind of situation has not occurred in the past 60 years. Moreover, while economic data for the second half of 2009 were inflated by the governments’ tax boosts and a very favourable comparison effect (to the extent that economic activity practically ground to a halt at the end of 2008 / start of 2009 after the failure of Lehman Brothers), this will not be the case in the coming months. Economic data published in the past few weeks are, in this respect, rather worrying.

What I have said above does not mean that equities should be shunned completely; it is, however, an opportunity to adapt one’s strategy to the kind of market we are in. In a structural bull market, such as the one of the 1980s and 1990s, a passive ‘buy-and-hold’ strategy is justified given that the upward trend of the market is such that in five to 10 years, share prices will sharply increase. In a sideways market, however, an active strategy is required. Our investment strategy in equities continues to be driven by the following points:

- dynamic management of the percentage invested in equities;

- a structurally increasing weight given to emerging markets (taking advantage of corrections on these markets);

- the identification of segments or companies which are attractively valued or whose outlook is well above the average (after all, the fact that stock market indices are below their level of 10 years ago, has not stopped the share prices of Danone, Nestlé or Procter & Gamble from practically doubling over the same period). Our favourite segments are currently quality companies and companies paying out high and stable dividends (cf. my post of 22 February). Note also that historically, around three-quarters of the equity return has come from dividends.

BL-Global Flexible: Situation as at mid-February

2010-02-23T14:18:25+01:00

The fund took advantage of the correction on the stock markets to slightly increase its net equity allocation, which, at 19 February, was 34%, up from 30% in mid-January. However, while one month ago this allocation was the result of the fund holding 55% in equities, 25% of which were hedged through the sale of futures, BL-Global Flexible currently has 72.5% of its assets in equities, 38.5% of which are hedged through futures.

Using derivatives to achieve a net equity allocation of 34% may at first sight seem more risky than a classical structure consisting of ‘simply’ holding 34% in equities. The fact that we have increased the percentage invested in equities whilst also increasing our hedging is due to our conviction that the quality companies held by the fund should outperform the market, either on the upside or the downside. The reasons behind this conviction are described in yesterday's post (see Market Analysis). It is also important to underline that not using futures would force us to keep a high proportion of the fund’s assets in cash, currently returning practically nothing, given that the percentage invested in bonds is only 22.5%.

The bond portfolio remains mainly invested in government bonds, with the corporate bonds portion having even been reduced following their good performance in 2009. As far as the eurozone is concerned, the only government bonds held are issued by Germany and the Netherlands. Euro-denominated bonds represent 15 % of the portfolio, with the remaining 7.5 % invested in US, Australian and New Zealand dollars, Norwegian krone, Brazilian real and Indonesian rupees.

Quality companies are relatively cheap

2010-02-22T15:38:54+01:00

At the risk of sounding repetitive, there seems to be very limited upside potential for the stock markets of the industrialised countries over a three to five years time horizon from end-2009 levels. This may seem surprising after a decade of stagnation on the markets: however, it is the outcome of the extreme overvaluation of equities at the end of the 1990s. Nonetheless, the very low level of interest rates and the deterioration in public finances will keep investors on the look-out for alternatives to money-market and bond investments. In light of this, I believe that an active strategy is more than ever necessary when investing in equities.

One aspect of such a strategy involves trying to identify within markets regions, segments or companies that are undervalued or that have a better than average outlook. Currently, quality companies fit into this definition (by quality companies, I mean companies with low debt levels, a strong self-financing capacity and low fixed costs and generating a high return on equity). Whereas the rally on the markets in 2009 has resulted in many risky companies being overvalued once again, the valuations of companies such as Coca-Cola, Nestlé and Procter & Gamble do not seem excessive.

Simply buying the shares of quality companies is one option. A more defensive strategy would involve betting only on quality companies outperforming the market. While in the first scenario, investors will only generate a positive return if the stock price of the companies they bought increases, in the second scenario they will earn money if the stock price of these companies increases more than the market OR falls less than the market.

Currently, this second strategy makes sense for a number of reasons:

- First, we could argue that given that quality companies are intrinsically better than the average, they should outperform the market, which represents this average. This reasoning makes sense over the long term, but not necessarily over shorter time periods. Historically, quality stocks tend to underperform in two situations: when they have become too expensive, and/or in the first phase of recovery after a sharp slump on the markets. In this phase, investors tend to favor companies whose prices have fallen the most, or whose earnings are expected to rebound sharply;

- Both scenarios were present at the start of 2009. Quality stocks fell much less than the market in 2008 and starting in March, investors had begun anticipating an economic recovery and were buying cyclical companies and financials. Quality companies thus underperformed in 2009 (shown in the chart that compares the share price of Procter & Gamble and Johnson & Johnson with the Standard & Poor’s 500 index). A similar situation occurred during the stock market recovery in 2003;

Source: Bloomberg

- The situation at the start of 2010 is quite different, however. As quality companies underperformed last year, they are now reasonably valued in absolute terms, but cheap in relative terms – i.e. compared to the market and lesser-quality companies. Instead of trading at a premium, many of these companies are even trading at a discount to the rest of the market;

Price/Book Value: High Quality – Low Quality

Source: Datastream, Crédit Suisse Research

- A look at the history of the stock market shows that the outperformance of lower quality companies lasts on average around ten months. And since the start of the year, quality companies have indeed started to outperform the market again.;

- The economic environment will remain challenging and hopes of a sustainable recovery in the economy are likely to be dashed. This kind of environment is not conducive to lesser-quality companies outperforming.

Finally, the quality theme is linked to the dividend theme that I have highlighted on many occasions. One could in fact argue that the best indicator of the quality of a company is its ability/willingness to pay out a regular and growing dividend. The fact that in 2009, the stock price of the 137 companies in the S&P 500 not paying out a dividend has increased on average more than twice as much as that of the 363 companies that do, seems thus rather perplexing!

BL-Global Flexible as at mid-January

2010-01-19T18:05:59+01:00

Review of 2009:

The fund’s strategy remained relatively defensive throughout the year. We took advantage of the fall in the stock markets in the first two months of the year to raise the equity weighting above 60% at the start of March. Following the sharp rally in share prices between March and May and given our lack of conviction about the sustainability of the economic recovery, we then decided to significantly reduce our exposure to equities again. Since May, the equity allocation has been fluctuating more or less in a range between 25% and 30%. Within the equity portfolio, we gave priority to the themes of ‘quality’ (e.g. Coca Cola and Nestlé), ‘income’ (companies paying out high dividends) and developing countries (Southeast Asia).

S&P 500 index and BL-Global Flexible equity allocation

The bond weighting in the portfolio was also actively managed. We believe that the ‘fair’ value for the 10-year yield (using the German Bund as our benchmark) in euro is currently around 3.5%. This figure is obtained by taking account of three factors that determine long-term interest rates, i.e. the eurozone’s long-term growth potential, inflation and a maturity premium. Using 3.5% as our starting point, we have defined a range of 3% to 4% with the aim of increasing the bond weighting (or the duration in the bond portfolio) in the upper portion of this range and reducing it in the lower portion. The bond portion has mainly been invested in government debt. The weighting of bonds denominated in currencies other than the euro has gradually been increased mainly through purchases in Norwegian krone and Australian dollars.

10-year interest rate in euros and BL-Global Flexible bond allocation

The Net Asset Value of BL-Global Flexible gained 14.47% in 2009.

Performance of BL-Global Flexible compared to MSCI AC World index

2010 strategy:

My ‘investment strategy 2010’ post from 11 January explains why we continue to believe that the economic and stock market recovery of 2009 will not be sustainable. In light of this, we continue to focus on an active contrarian strategy that consists of buying when the markets fall and selling when the markets rise. This applies to both equities and bonds.

In terms of equity allocation, our range is as follows and is obviously subject to review:

S&P 500: 600 700 800 900 1000 1100 1200

Percentage of equities: 80% 70% 60% 50% 40% 30% 20%
(indicative)

It is important to note that the percentage of equities is a net percentage. The gross percentage may be higher and the difference is because a portion of the equity portfolio may be hedged through the sale of futures. On 15 January, the net equity allocation was 30% (55% gross including 25% hedged through futures on the S&P 500, the Stoxx 50 and the FTSE 100).

The geographical allocation of the equity portfolio is as follows:

- Europe: 27% (hedged at 17%)

- North America: 12% (hedged at 8%)

- Emerging markets: 9.5%

- Japan: 6.5%

The 'regular income' theme is extremely important in the equity portfolio, particularly in Europe. The (net) average dividend yield is currently 5.7% for eurozone stocks and 4.6% for UK stocks.

In the bond portion, the 3% - 4% range discussed above remains valid. On 15 January, bonds represented 27% of the portfolio, with 21% in government bonds (Germany, Netherlands, Norway, Peru, and South Korea) and 6% in corporate bonds (KPN, Heineken, Nestle, Bayer, and BP). Euro-denominated bonds represent 20% of the portfolio, with the remaining 7% invested in Australian and New Zealand dollars, Norwegian krone, Brazilian real and Indonesian rupees.

Investment strategy 2010

2010-01-12T10:29:31+01:00

Those who have knowledge don't predict. Those who predict don't have knowledge.

Lao Tzu

This time last year, I wrote that the New Year tradition of making forecasts for the year to come was an even more perilous exercise than usual. My reasons at the time were linked to the lack of visibility on the economic situation and the uncertainty on the banking landscape.

It is clear that the measures taken by the authorities have succeeded in restoring confidence to the banking system and have brought stability - and even a boost - to economic activity which had come to a complete halt following the failure of the Lehman Brothers investment bank. But the authorities have achieved this at the expense of their own financial situation which has deteriorated to such an extent that most industrialised countries have seen an unprecedented increase (in peace time anyway) of their budget deficit and their debt levels. In other words, the remedy for a crisis caused by excessive debt in the private sector and banking sector is supposed to be an unprecedented level of debt in the public sector. Such a situation could lead to serious problems in the longer term, especially since the impact of demographic trends on pension systems is also likely to weigh on public finances in some years’ time.

Against a backdrop of near-zero interest rates, the stabilisation of the economic and banking situation, and the outlook for economic recovery have set off a sharp rally in risk assets. 2009 served to remind us that in the short term, cheap money gains the upper hand over fundamentals, and that it is important to know exactly what is factored into prices. One year ago, the markets were anticipating a very negative scenario. All it took was for that scenario not to happen for the markets to start rising again.

The current recovery is artificial (driven by public spending) and statistical. Businesses restoring inventory may help to spur growth of 4% in the US economy in the fourth quarter 2009 and the first quarter 2010. There is however no avoiding the fact the deleveraging process embarked on by Anglo-Saxon consumers (less consumption) and the banks (less credit) will weigh on growth in the years to come.

So while the traditional new year forecasting exercise seems once again difficult, this year it has less to do with the lack of visibility on the economic situation and more to do with the sheer range of possible scenarios for 2010. I have said on a number of occasions that while the recovery in share prices since March has not been based on solid fundamentals, it is relatively easy to construct a favourable scenario for equities. Such a scenario is based on a continuation of the situation of the past few months in which the bad news is ignored and good news is amplified, the authorities pull out all the stops to maintain a dynamic of recovery and the low levels of interest rates push investors towards the stock markets. The inflation that so many analysts predicted would accordingly be reflected in the financial sphere and not in the real economy. Similarly, while the current environment marked by uncertain growth, near-zero money-market rates and lack of inflation is in principle favourable for government bonds, we could also imagine a situation in which long-term interest rates rise sharply giving way to a bond market crash. In this scenario, bond yields would surge not due to inflation, but rather due to an imbalance in supply and demand for government bonds, with investors no longer able or willing to finance the increase in supply (due to budget deficits) at current yields. If we combine both, we could even imagine what might seem at first sight a rather perverse situation in which equities would become the safe haven for investors who have lost confidence in government debt. Finally, there is always the chance that the economic recovery may turn out to be unsustainable but where bond yields increase nevertheless precisely due to the high supply of government bonds. Such an environment would, on the contrary, be highly negative for the stock markets.

But deploring the lack of visibility or discussing possible scenarios does not count as an investment strategy. Doing nothing is also a decision and the fact that money-market investments are today offering almost no returns is increasing the opportunity cost of such a decision. After all and with just a touch of exaggeration, with short-term rates touching zero, the stock and bond markets cannot return less than a money-market investment in 2010 unless they fall.

I felt this little introduction necessary to show that there is no point in being too dogmatic at this time. It will be important to be ready to review one’s investment strategy over the year. In the words of Keynes: "When the facts change, I change my mind. What do you do, sir?" With that said, here are the ideas that will underpin our investment strategy for 2010:

- The recovery in share prices since March 2009 has not heralded the start of a new structural bull cycle for the US and European stock markets. In 1982, when the markets began their last bull cycle, the situation was completely different. The table below compares the situation at the time with the situation today:

United States	1982	2009
Fed funds rate	18% and only one way to go (down)	0% and only on way to go (up)
10-year bond yield	15% and falling	3.8% and ?
Budget deficit-to-GDP ratio	-3% and moving towards a surplus	-10% and steady or falling from here
Household debt-to-personal disposable income ratio	62% and rising	123% and falling
Inflation rate	10% and falling	0% and rising (inflation) or falling (deflation)
Savings rate	10% and falling	4% and rising
Unemployment rate	10.8% and falling	10% and rising
Tax rates (highest marginal)	69% and falling	35% and rising
Global trade barriers	High and falling	Low and rising
Profit margins	6.0%	10.0%
S&P500 P/E ratio	8.0x	20.0x
S&P500 price-to-book ratio	1.0x	2.2x
S&P500 Dividend Yield	6.0%	2.0%

Source: Gluskin Sheff

A passive buy-and-hold strategy is therefore not appropriate in the current context. The best is to adopt an active approach, both in terms of asset allocation and stock-picking;

- In terms of asset allocation, the active strategy that makes the most sense in this type of market in my opinion consists of increasing equities when prices fall and lowering them when prices rise (bearing in mind that as prices tend to fall on negative news it is more difficult to convince oneself to buy, the opposite of which is true when prices rise). In the long term, this strategy is the closest to the objective set by all investors - i.e. to buy 'low' and sell 'high'. One year ago, I had suggested a range of 600 to 1000 for the S&P 500 index, which turned out to be relatively accurate as the index fluctuated in a range between 670 and 1100. For this year, we have revised the range upwards, if only to take account of the appreciation in share prices in 2009 and the fact that a certain number of risks that marked the start of 2009 have (temporarily?) disappeared. Currently, we are applying a range of between 600 and 1200 in our portfolio management with a neutral equity allocation of 900, which is obviously subject to review. If we take the example of the BL-Global Asset 50 fund for which the neutral equity allocation is 50% with a maximum allocation of 65% and a minimum allocation of 35%, the percentage of equities would be adjusted as follows:

S&P 500

600

700

800

900

1000

1100

1200

Percentage of equities

65%

60%

55%

50%

45%

40%

35%

The result of the foregoing is that we currently prefer a defensive investment strategy, as the market is in the upper portion of our chosen range;

- The range mentioned above could be considered too prudent, especially in a context of very low interest rates. Low interest rates are not, however, a sufficient enough reason to justify investing in equities, especially when, as is the case right now, rates are low due to extremely fragile economic fundamentals. Broadly speaking, equities are overvalued and are pricing in a highly favourable scenario with expected growth in earnings of more than 30% in 2010 (for S&P 500 companies);

- In terms of geographical allocation, I am maintaining my favourable stance on the emerging markets (South-East Asia and Brazil), as the fundamentals of these countries are better than the industrialised countries. However, I believe that in the short term, these markets are overbought and before buying again, I would tend to wait for a price correction, which could be spurred, for example, by the appreciation of the dollar, tightening of credit conditions in China or the abundance of new share issues planned for this year. In the longer term, the challenge for investors will be to identify companies that will benefit from the theme of increased domestic demand in these countries, given that their indices are generally dominated by exporting companies. In this respect, telecommunications stocks currently seem attractive, especially given the fact that prices have hardly risen in 2009;

- As far as stock-picking is concerned, the two themes that continue to dominate our strategy are ‘quality companies’ and ‘regular income’. By ‘quality companies’, we mean companies with low levels of debt that have a strong self-financing capacity, low fixed costs and high levels of profitability. These companies have broadly underperformed in the rebound since March 2009 as investors focused on companies more likely to benefit from the economic recovery. The ‘regular income’ theme means we are giving priority to companies paying out high dividends, on the condition of course that these dividends are not at risk. These have also underperformed during the recovery. In 2010, they could benefit from the desire of many investors to find an alternative to fixed-rate investments and their reticence to buy equities that have already sharply appreciated;

- I do not share the fears that there will be a crash in bonds in 2010. Although public finances in the industrialised world have deteriorated to worrying proportions, the current environment of near–zero money-market rates, the fragile recovery and contained inflation should prevent bond yields from rising sharply. Spreads between long and short interest rates are currently historically high in some countries.

For the time being, the increase in savings in the private sector is offsetting the avalanche of new loans issued on the back of the increased financing needs in the public sector. However, the example of Greece shows that investors will be more discerning as to which countries they invest in. As is the case with equities, an active investment strategy is necessary in bonds, as the objective is to increase durations after a period of rising yields and to lower them when these yields slide again;

- On the currency markets, it is worth remembering that everything is relative. It is easy to draw up a list of factors likely to weigh on the dollar but the situation with the euro is not brilliant either, given the lack of internal dynamic, an increasingly worrying situation in Southern and Central Europe, and a banking landscape that many experts deem much more fragile than the United States. From an economic point of view, the dollar (and the euro) should depreciate against the Asian currencies, but China continues to oppose any appreciation in its currency, which means that the euro is the main alternative for those wishing to exit the dollar. Currently, alternatives to the dollar and the euro are to be found in countries with solid fundamentals that are benefiting from the emergence of Asia. The outlook for the Australian, Canadian and New-Zealand dollars and the Norwegian krone seem good in this respect. In an environment characterised by inflation or deflation fears, a lack of confidence in the main currencies and extremely low interest rates, gold could continue to perform well, especially in light of the fact that gold production stagnated in the last decade.

The economic situation in Greece

2009-12-14T10:36:18+01:00

The inconsistencies that were predicted by many economists when the euro was introduced, but were masked by the favourable economic situation between 2000 and 2008, have now come to light with the problems in Greece.

As the European Central Bank’s monetary policy is essentially based on the economic situation of the “large countries”, and more specifically, Germany and France, the Southern European countries' membership of the euro has enabled them to enjoy much lower interest rates than those to which they were accustomed when they had their own currencies. The authorities in Southern Europe have not taken advantage of these rates to reduce their debt – Greece, for example, continues to record an annual budget deficit of more than 5% despite growth rates well above the average for the eurozone (on this note, one could also speculate about the reliability of Greece’s economic data as the government has just revised the deficit for the 2009 fiscal year upwards from 6% to 13%).

The low level of interest rates has also given rise to excessive consumption and favoured the appearance of speculative bubbles (credit, housing, etc). Between 2000 and 2007, unit labour costs (output per worker per hour worked) rose by around 20% in Italy, Spain, Greece and Portugal, while in Germany, there was no change. The resulting excessive consumption and negative trends in labour costs led to the appearance of increasingly high external deficits. In 2008, Greece’s current account deficit was around 15% of gross domestic product. In terms of competitiveness, Greece has fallen to 71st place in the World Economic Forum index, below countries like Botswana. The fact that labour costs and the current account balance are not part of the convergence criteria set out in the Maastricht Treaty is one of the euro’s major weaknesses. This weakness is further accentuated by the lack of automatic transfer mechanism between countries in the eurozone, which contrasts with the situation between the various States in America.

The Southern European countries are now in a very precarious situation. As significant external deficits build up, their foreign debt levels are also rising (1). If their external debt to gross domestic product ratio continues to increase, there will come a day where foreign investors will expect a higher return for continuing to finance these countries, resulting in an increased debt service cost and the appearance of a vicious circle. This is what is happening in Greece.

In the past, Greece could have applied an easy remedy: devalue its currency and print money. This option is no longer possible since the country joined the eurozone. On the contrary, the strength of the euro is weighing on the country’s main industry, tourism. Since the start of 2006 the euro has gained 40% against the Turkish lire. In 2008 Turkey’s revenue from tourism rose, while Greece saw its tourism-based revenue slump.

The situation in Greece is not without hope however. In principle, the country may rely on the support of the other eurozone members. The government could undertake privatisation to lower debt. In a country where the black market is estimated at some 25% of Gross Domestic Product, increasing taxes would make a major contribution to reducing the budget deficit. However, the fact remains that finding sustainable solutions to Greece’s problems would require drastic austerity measures and result in falling living standards. In practical terms, neither the government nor the population seems willing to undertake such measures.
The imbalances described above are not new and have not prevented the euro from becoming the main alternative to the dollar on the currency markets. However, the fact remains that since the single currency was introduced, the imbalances have worsened and, unless there is a significant improvement in the economic situation, are likely to undermine eurozone cohesion. It is not for nothing that history shows that few monetary unions have survived.

What impact could Greece’s problems have on the financial markets? First of all, in an environment where everyone seems convinced that the only way for the dollar to go is down, the situation reminds investors that when it comes to currencies, everything is relative and that the euro also has its problems. Given the inverse correlation between the dollar and the stock markets (the dollar falls when the stock markets rise and vice versa), a recovery in the greenback could see equities correct. The more so since, for many investors, the dollar seems to have replaced the yen as the preferred carry trade currency. Furthermore, risk aversion, which, after soaring to heady heights in 2008, has been falling since March, could rise again. Finally, the example of Greece shows that bond markets are not willing to tolerate a never-ending increase in governments’ capital requirements.

(1) A country’s current account deficit results from the shortfall of national savings compared to total investments. It is important to note that economists often make the distinction between a situation in which this inadequacy is due to particularly high levels of investments and a situation in which it results from falling savings.
In the first case, foreign capital finances the expansion of production capacity which, in the longer term, should enable the country to increase output and reduce foreign debt without having to lower living standards. In the second case (the Southern European countries), foreign capital is only used to finance excessive consumption. Here the increase in the foreign debt to gross domestic product ratio becomes particularly worrying (although it is difficult to know in advance from when this ratio is no longer sustainable) and forces the countries concerned to reduce consumption and sacrifice some of their living standards.

BL-Global Flexible as at beginning of November

2009-11-17T12:55:48+01:00

As at beginning of November, the fund's net equity weighting is 28% (51% minus 23% hedged through the sale of futures). The geographical allocation of the equity portfolio is 24% Europe (net exposure: 8%), 16% North America (net exposure: 9%) and 11% Asia. The portfolio's sector allocation remains defensive with "Asia" and "dividends" as the main investment themes.

The bond allocation currently stands at 35% (29% government bonds, 6% corporate bonds). The percentage of bonds that are not denominated in euros remains at 8.5%. Most of these bonds are in "commodity" currencies that should continue to benefit from the secular theme of the industrialisation of Asia.

In sum, the asset and currency allocation in BL-Global Flexible looks like this:

Frequently asked questions (cont'd)

2009-11-09T17:47:06+01:00

In the following, I try to answer some of the main questions people have posted on the blog in the past few months. Due to technical problems that have now been resolved, I have only just seen these questions. I believe however that they are still relevant.

1. Questions about “Market analysis”

What are the ‘real’ causes of the financial crisis?

The main reason, in my opinion, is excessive debt. In light of this, I don’t believe that policies designed to stimulate even more consumer debt (for example the "cash-for -clunkers" subsidy) or forcing banks to give out loans (when these loans are not sufficiently guaranteed) are really the right solution. Similarly, replacing an overindebted private sector with an overindebted public sector doesn’t really seem like a good idea, either.

Do you believe that a new bubble is starting to form?

It’s hard to say. And yet, financial history shows us that periods of very low interest rates generally give rise to bubbles. These bubbles tend to form on assets that capture investors’ imagination (e.g. technology stocks at the end of the 1990s). From this point of view, the most likely bubble candidates today are emerging markets and commodities/precious metals given the Asian industrialisation theme.

What about gold?

I have always said that buying gold is a speculation and not an investment. This is due to the fact that gold has no intrinsic value, unlike stocks, which represent a claim on a company’s future earnings (cash flow, dividends, etc) or its assets. As gold does not generate interest or produce cash flow (and has only a limited economic utility), its only worth is what an investor is willing to pay for it at a certain moment in time.

To quote Warren Buffett: "Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Having said that, there are times when a speculation does make sense. Currently, there are plenty of arguments in favour of gold:

- The very low level of interest rates considerably lowers the opportunity cost of an ‘investment’ in gold;

- The fear of seeing governments printing money to finance their excessive debt results in a loss of confidence in paper money;

- After having doubled between 1980 and 1999, the production of gold has since stagnated;

- Demand from Asian countries, especially China and India is strong.

Inflation or deflation?

Currently deflation is a reality, while inflation is a possibility. What I mean by this is that the current economic environment, which is characterised by rising unemployment and production overcapacities, is clearly deflationary. In the longer term, there is a risk that the monetary and budgetary policies currently being implemented will result in rising inflation. However, high budget deficits do not necessarily lead to high inflation (as the Japanese situation has shown for many years). A lot will depend on the way the authorities act in the future.

2. Questions about “Fund management”

Why do you not hedge part of your exposure to Asian stocks?

Our outlook for the Asian markets is positive in the long term and we prefer to restrict our hedging to the US and European markets.

Why do you have USD positions?

Experience shows that the dollar is currently inversely correlated with the stock markets (it depreciates when the stock markets rise and appreciates when they fall). In light of this, it deserves a place in BL-Global Flexible, the aim of which is to have a portfolio that can stay the course in various economic and market scenarios.

Isn’t there a risk of a crash on the bond markets?

The risk is linked to the prospect of soaring inflation coming back again. As explained above, it will be important to keep an eye on this, but currently we are in a deflationary scenario that is rather favourable for the bond markets (by the bond markets, I mean government bonds, which make up most of our bond holdings in BL-Global Flexible).

Apart from the inflation risk, there is the possibility that a government can no longer repay its debt, a risk that increases in a deflationary environment. This risk cannot be overlooked and is more important for the eurozone given that recourse to printing money (the central bank prints money that it uses to buy bonds a government issues to finance its deficit) is much more difficult than in the case of the US for example. This is why the only eurozone bonds held by BL-Global Flexible are those issued by Germany and the Netherlands.

Performance of BL-Global Flexible since start of year?

The fund has gained 12.21% since the start of the year.

BL-Global Flexible as at beginning of October

2009-10-13T10:32:31+02:00

As at beginning of October, the fund's net equity weighting is 27% (46% minus 19% hedged through the sale of futures). The equity allocation has slightly increased compared to early September when it stood at 22%. This is due to the rising markets but also to some new purchases, especially in the energy sector where ENI and Total are two examples of companies paying a high dividend and whose share price has barely increased since the beginning of the year. The geographical allocation of the equity portfolio is 23% Europe (net exposure: 8.5%), 12% North America (net exposure: 7.5%) and 11% Asia. The portfolio's sector allocation remains defensive, particularly in Europe where dividends remain a major investment theme. The average gross dividend yield for eurozone equities (18% of the portfolio) is thus around 7%. The funds is not invested in financials.

Following the recent good performance of the bond markets, the bond allocation was reduced to its current level of 37% (31% government bonds, 6% corporate bonds). The percentage of bonds that are not denominated in euros has however been increased to 8.5%. Most of these bonds are in "commodity" currencies that should continue to benefit from the secular theme of the industrialisation of Asia.

In sum, the asset and currency allocation in BL-Global Flexible looks like this:

FAQs

2009-10-12T17:43:41+02:00

@GW – You seem quite pessimistic about the economic situation. But a number of indicators are now pointing to recovery.

It is very important not to confuse factors that are temporary with those that are sustainable. In the short term, the economy might well continue to benefit from temporary factors such as the economic stimulus plans put in place by governments and corporate inventory restocking. But governments cannot eternally increase their spending and corporate restocking will quickly stop if there is no final demand. To get a lasting recovery, we need sustainable growth impulses. The signs are not particularly encouraging in this respect. The US consumer and the banking sector, whose ever-increasing recourse to leverage had inflated economic growth in recent years, have now entered a deleveraging process that will last for years and is likely to weigh on economic recovery.

The growth model of recent years seems to me to have run its course. Under this model, the global economy was led by the United States, the US economy by the consumer, and the US consumer by a decline in savings and an increase in debt. To realign the global economy, the United States will have to save more while countries with a high savings rate and a trade surplus will have to consume more. Simplifying this somewhat, the Asian consumer will have to replace the US consumer as the growth engine for the world economy. This won’t happen overnight despite some encouraging developments. To accelerate the transition of Asian countries from growth based on exports to growth based on internal demand, they will have to accept a strong appreciation of their currencies which are significantly under-valued at present. As for the industrialised countries, it is disappointing to see that their stimulus programmes are often characterised by a determination to perpetuate the growth model of recent years that promotes consumption – the car scrappage scheme being a good example.

@GW – You often say that the valuation of the equity markets is not attractive. But many analysts are saying that stocks are cheap.

If we start from the hypothesis that the global economy is at the dawn of a strong and sustainable recovery, it’s true that shares are not too expensive (though I think "cheap" is a bit exaggerated). In the United States, the increasing consensus among analysts is that companies in the S&P 500 will gain an average of $75 per share in 2010. The S&P 500 index is currently trading at around 1066, which would give a price/earnings ratio (PER) of around 14, slightly below the historic average.

The answer to the question of deciding whether shares are currently at attractive valuations or not therefore depends on one’s view about which way the economic situation will go. If, as I think, the recovery is not going to live up to expectations, profit forecasts for 2010 will be disappointed and the valuation of the markets is not attractive. If on the other hand, the recovery is strong (and sustainable!), company results could be pleasantly surprising, especially as many companies have used the opportunity of the crisis to dramatically reduce their cost structure.

In saying the above, I have used the price/earnings ratio (PER) as the basis for judging the valuation of shares. The problem with this ratio is knowing what denominator to use: earnings (known but depressed because of the recession) of the last 12 months? Estimates for 2010? To get round this problem, analysts often use other ratios such as the Shiller PER, where the denominator is the average earnings for the last 10 years (the idea being that taking an average of 10 years will have a smoothing-out effect), the price/book ratio or even the dividend yield. Based on any of these ratios, shares are currently not cheap.

@GW – Isn’t it possible that the high levels of cash waiting on the sideline will lead to a continuing rise in share prices despite the absence of any improvement in the fundamentals?

I think we should be extremely cautious with the argument currently being advanced of "abundant liquidity". This argument is generally used when people can’t think how else to explain a rise in share prices. In the past, we have often seen that liquidity that was thought to be abundant could disappear from one day to the next. In fact, I don’t think that liquidity today is that much higher than at the beginning of March when stock prices were 35% lower, even though it is true that the liquidity that governments have injected into the system is tending to find its way into financial assets since the real economy doesn’t need it.

Whatever the case, a strategy that consists of recommending equities not because of their fundamentals or their valuations but because of arbitrary factors such as liquidity is incompatible with our investment philosophy. We then enter the realms of speculation.

@GW – You recommend a defensive strategy. Does that mean you think an equity market correction is imminent?

I try to avoid making forecasts about what will happen to share prices in the short term since this is often totally decoupled from the fundamentals. But having said that, it is obviously possible that share prices could be higher at the end of 2009 than they are today, with the real test for the markets coming in 2010. In the short term, the stock markets might continue to benefit from a very favourable environment: investors have chosen to ignore bad news (the reaction of the markets to bad US unemployment figures in September being a case in point), company profit forecasts for the third and fourth quarters have been revised sharply downwards (so a great many companies will now be able to beat them), and the authorities have let it be known that they are not going to increase interest rates any time soon. But this type of short-term reasoning is just that (i.e. short-termism), and should not serve as the basis for a serious investment strategy.

@GW – So should we be abandoning equities completely?

No. Instead, what I think we should be doing is abandoning sweeping generalisations like “What will the markets do?” and look closely within the markets to see if there are regions/sectors/companies that combine solid fundamentals with a reasonable valuation. Without talking about individual stocks, I would focus on three major themes:

the industrialisation of Asia (linked with the commodities theme);
quality companies (defined as companies with sustainable high profitability, low leverage etc.), which have generally underperformed in the market recovery since March and whose valuation is now attractive;
dividends.

An economic recovery?

2009-09-10T17:30:26+02:00

You might be surprised at my reticence to believe in a sustainable improvement in the economic situation when every day the media seem to be presenting us with encouraging economic statistics. So here is a brief summary of my reasons:

- First of all, in many cases, the signs of recovery that investors seem to be detecting are nothing more than a stabilisation of certain indicators that had previously fallen to their lowest level for several decades. Such a stabilisation is not particularly surprising. The decline in economic activity after the Lehman collapse was so extreme that a slowdown in the deceleration rate was logical.

- Then, following the same line of thinking, the indicators that point to an economic upturn are indicators related to production. The shock caused by the elimination of Lehman Brothers led a whole host of companies to virtually cease production. That led to a situation in which production was unable to satisfy demand, notwithstanding how weak that demand was. In recent months, production has had to play catch-up, which has given rise to the famous 'green shoots' concept. And it is these green shoots of economic recovery that have fuelled the stock market rallies, with the rallies themselves then being seen as proof that the economic and financial crisis was behind us.

- And lastly, the stabilisation of the economic situation has only been achieved on the back of a massive increase in public expenditure. In the United States, the 'cash-for-clunkers' car scrappage scheme has influenced a raft of economic indicators. The improvement in these indicators has subsequently been taken as a sign that recession is over. This programme has been such a success that it has now been extended to domestic appliances. This could well sustain growth in the second half. But the question will still be whether this improvement in economic activity can prove sustainable. I continue to think that given the fundamentals of the US consumer, it will be difficult for the US economy to maintain a growth dynamic when the contribution of the current public stimulus programmes comes to an end. Especially as these programmes have borne the hallmark of a willingness to perpetuate a growth model based on increasing consumer spending. They have thus not only deferred the necessary adjustment of the financial situation of American households, but have, on the contrary, aggravated this situation by inciting the US consumer to take on more debt to buy a new car (or a house now that the Federal Housing Administration is providing new mortgages with a down payment of only 3.5%). At the same time, these programmes have led to a ballooning of the budget deficit and public debt without laying the bases for an increase in the US economy’s medium to long-term growth potential. The United States is therefore increasingly faced with a dilemma: reduce the budget deficit by cutting public expenditure and/or increasing taxes, which would risk plunging the economy back into recession, or not cutting public expenditure which would lead to a debt level that becomes increasingly difficult to finance.

It is entirely possible that in the second half of this year, figures will show positive growth (experts in the United States are suggesting growth of nearly 4% in the third quarter). However, the first question will be to see how this recovery could prove sustainable in a context where the traditional components of growth – household consumption and corporate investment – remain weak. In the longer term, a second question will relate to the consequences of the budgetary and monetary policies currently being conducted and the incapacity of governments to attack the real causes of the economic and financial crisis.

With a rise of over 50% in six months, the stock markets have clearly anticipated the economic recovery. To justify a further increase, we will need tangible proof of this recovery before long. As for the "good" company results that the market seems to be so enthusiastic about, they are:

1. relative (in other words they are good compared to expectations that had been lowered considerably), and

2. the fruit of extremely good cost control. But a strategy of cost control has its limits and sooner or later, companies tend to find they have to boost their sales in order to improve their results. This will only happen if the economic context improves. Meanwhile, the US market is trading at 130 times reported earnings and at 25 times operating profits (which exclude exceptional expenses) of the last twelve months.

Adopting a defensive strategy does not mean completely abandoning equities, especially since money market investments, with remuneration close to zero, hardly offer an attractive alternative (although low interest rates are not a sufficient reason to invest in equities). But stock selection will become more important than ever. Companies to focus on should meet the following criteria:

1. superior quality – low debt level, high cash flow from operations, low fixed costs;

2. low sensitivity to economic growth;

3. appropriate transparency.

Contrary to what one might think, this type of company has considerably under-performed in the rally of recent months, with investors favouring companies of lesser quality that are more leveraged to an economic recovery.

In a deflationary environment, the search for regular income should also constitute a priority for investors with dividends thus remaining a key investment theme.

BL-Global Flexible as at beginning of September

2009-09-03T09:46:54+02:00

We have taken advantage of the rise in stock markets over the last 2 months to reduce the equity allocation in the BL-Global Flexible fund even further. As at beginning of September, the fund's net equity weighting is 22 % (41 % of which 19 % is hedged through the sale of futures). As I mentioned in my article from 14 August in the "analysis" section of the blog, I think that the economic fundamentals do not justify the rise in stock prices that we have seen since March. A lot of investors are frustrated to have missed out on this rally, even though in March, it would habe been impossible to convince them to buy equities. This reminds one of one of the 10 market rules of Bob Farrell, the former strategist of Merrill Lynch: "Fear and greed are stronger than long-term resolve". The geographical allocation of the equity portfolio is 20 % Europe (net exposure: 5 %), 10% North America (net exposure: 6% ) and 11 % Asia (net exposure: 11 %). The portfolio's sector allocation remains defensive, particularly in Europe where dividends furthermore remain a major investment theme.

The expectations of a strong economic recovery that are behind the rebound in equity markets have not led to a sell off in government bonds and long-term bond yields are actually lower today than at the beginning of July. The fears of inflation that were behind the rise in bond yields during the second quarter have been laid to rest (temporarily?) as the recent statistics on consumer and producer prices have shown the depth of the deflationary trends that the world economy is facing. The renewal of Ben Bernanke's federal Reserve Chairmanship should also mean that short-term interest rates will be kept near zero for an extended period of time. The bond allocation in the BL-Global Flexible fund currently stands at 46 % of which 38 % are government bonds and 8 % investment grade corporate bonds. 40 % of these bonds are denominated in euros, the remaining 6 % being in the Norvegian krone, the Australian dollar and the Brasilian real.

In sum, the asset and currency allocation in BL-Global Flexible looks like this:

A defensive investment strategy - part 2

2009-08-20T10:42:55+02:00

"If something cannot go on forever, it will stop" (Stein's Law)

There is no doubt that the recovery on the equity markets since March has been impressive. Since their lows of 9 March, the European and US markets have bounced back by around 45 %, while for some of the emerging markets, the figure was closer to 100 %. And although the sharp recovery that started in March seemed to be gradually losing steam by May, the markets began soaring again in mid-July. I think it is therefore useful to look back on the factors that prompted me to recommend a defensive strategy at the start of July and see whether they are still relevant.

The following explanation is usually given for the recovery on the markets since March: at the start of March, the stock markets were discounting a nightmare scenario and equities were extremely undervalued. Large-scale interventions by the authorities then stabilised the banking sector. The stimulus programmes implemented by the various countries thereafter laid the foundations for economic recovery. Recent data shows that the recession is over. In the second half of the year, economic growth is expected to be boosted as businesses start rebuilding their inventories. The recovery in corporate earnings, the low level of interest rates and the amount of excess liquidity continue to support stock markets, especially as equities are not overvalued on the whole.

Although this reasoning seems logical, it has a number of flaws.

First, while it is true that stock markets were oversold in March, they were not extremely undervalued. Multiples at that time compared favourably to the average of the past 25 years, but were still much higher than those seen at the end of the great bear markets of the past (see my article of 7 April). Those markets ended on average with multiples some 30% lower than those seen in March. In this light, the assertion that the markets were discounting an economic depression 5 months ago seems exaggerated to say the least.

Second, despite the current calm, the problems in the banking sector are far from being resolved. The Bank for International Settlements (BIS) said recently that only limited progress has been made in clearing up the global financial system. The deterioration in the situation in the commercial property market is likely to create new problems for banks. In May, the commercial mortgage delinquency rate in the United States was 2.7%, its highest in 10 years. According to Federal Reserve data, at the end of 2008, around 12% of financial institutions had commercial real restate loans that exceeded five times their basic capital, contrasting with 2% in 1993.

Finally, even though recent economic indicators seem to show that economic activity is no longer deteriorating, most of these indicators fall into the category ‘not as bad as expected’ rather than ‘good’. The stabilisation in economic activity has only come about thanks to massive government expenditure whose future cost to society is currently impossible to evaluate. In the United States, the contribution of the stimulus programmes to growth will soon pass its peak and, short of new programmes being launched despite a record budget deficit, will gradually run out of steam. The common thread running through all the stimulus programmes is the desire to perpetuate the growth model of the past 25 years by artificially boosting private consumption rather than the desire to put the economy back on track for sustainable long-term recovery. The renewal of the Cars Allowance Rebate System (CARS), also known as ‘Cash for Clunkers’, at the start of August, a subsidy designed to boost the automobile market, is a good example of this. The programme has managed to stem, or at least slow, plummeting car sales in the United States. Car sales accordingly rose to their highest level in 10 months in July. The recovery in the automobile sector is currently having a positive impact on a number of economic indicators. Most economists are forecasting growth of between 3 and 4% for the current quarter with some estimates running as high as 5%. The fact remains that the programme is only bringing forward future demand and once it comes to an end, the positive impact on the economy will quickly fade away. According to a recent survey by the CNBC channel, 90 % of economists in the United States believe the recession is over. There is however currently no certainty that without the help of massive government spending, the US economy is able to stand on its own two feet.

That economic activity being close to bottoming out, or even at the dawn of a period of robust growth in the second half of this year is one thing: more important, however, at least for investors with longer investment horizons, is the fact that the conditions for a sustainable recovery are not in place. In my article of 8 May, I explained why I believe economic growth is likely to disappoint in the coming years. The main reason is that the US consumer and the financial sector, whose continuous increase in leverage had inflated growth in the past two decades, have embarked on a process of deleveraging that is expected to last for a number of years. In April and May, American households thus saved the tax credits offered by the government rather than spending them (which is why the US savings rate surged from 0.4 % in August 2008 to 6.9 % in May). The deterioration in the labour market will not encourage the US consumer (70 % of the American economy and 20 % of the world economy) to quickly abandon his/her new thrift. As Bob Herbert wrote recently in the New York Times: "How do you put together a consumer economy that works when the consumers are out of work?" Meanwhile, in the banking sector, the latest figures show a record decline in lending to households and businesses.

In my article of 8 May, I discussed the risks of a defensive investment strategy saying:

- that my pessimism about the ability of the US economy in particular and the world economy in general to stage a strong sustainable recovery might be overdone;

- that economic activity might recover temporarily before slumping again;

- that the stock markets would continue to benefit from significant liquidity inflows.

Although these risks are still present, they are much less significant today for the simple reason that the markets have gained around 10% since May. It is always helpful to bear in mind that as equity markets rise, good news is more and more discounted. At the start of March, most investors were very pessimistic, and it was enough for news to be a little less bad than expected to spark a recovery on the stock markets. Today, the markets are 50 % higher and at current levels, a significant recovery is starting to be priced in. It is important to note that another argument usually put forward to justify the recent rise on the markets, i.e. that most companies' second-quarter results were better than expected, needs to be put into perspective. First, analysts had lowered their estimations over the past few months to such a low level that expectations were not very high. Second, as in the first quarter, company sales were overall very disappointing. Profits were better than expected because of very good cost control. A strategy of cost control is only efficient to a certain point however, especially since the costs of one company are the revenues of another, or, in the case of labour costs, the revenues of households.

In sum, a defensive strategy seems more necessary than ever. A rise of around 50% in share prices in 5 months is rare. There are more or less four precedents in the history of the stock markets. It is interesting to note that two of these happened during the great bear market of the 1930s. The third occurred in 1974-75. In each case, if an investor had bought after such a rebound, he would have experienced significant losses in the years after. The exception is the period between August 1982 and January 1983, which marked the start of the great bull market which lasted until 2000. The current situation is not comparable to that period. In 1982, equities were extremely undervalued. After two oil crises, inflation, and, by extension, interest rates were high. The decline in inflation and interest rates in the following years contributed to the world economy entering a new era of prosperity and gave rise to a revaluation of equities. Today, equities are much more expensive and the current economic environment is marked by strong deflationary trends and low interest rates. Such an environment is not conducive to higher valuation multiples.

BL-Global Flexible: Portfolio as at beginning of July

2009-07-07T17:50:15+02:00

As I mentioned yesterday in my article in the "Analysis" section of the blog, I believe that the expectations of economic recovery behind the rise in risk assets since March will be short-lived. This view is reflected in the BL-Global Flexible fund. The fund’s net equity weighting is 30% (44% of which one third is hedged through the sale of futures). The geographical allocation is 19% Europe (net exposure: 9%), 12% North America (net exposure: 8%) and 13% Asia (net exposure: 13%). The portfolio’s sector allocation is defensive, particularly in the eurozone where investments are concentrated in companies paying out high dividends (the average gross dividend yield of this portion is 7.3%) and whose activity is less dependent on the economic situation.

The rise in long-term interest rates has enabled us to increase the bond weighting to its current level of 49%. The fears of inflation behind the recent rise in long-term interest rates seem at the very least premature in an environment of plummeting capacity utilisation rates and rising unemployment. The government / corporate bond allocation is 41%/8%. While the fixed-income portfolio is mainly invested in euro-denominated bonds, over the past few weeks, positions have nevertheless been taken in the currencies of countries whose economic fundamentals and outlook are more promising than the eurozone. This explains our decision to invest in bonds denominated in Norwegian krone, Australian dollars and Brazilian real, which take up 6% of the portfolio. The characteristics of the bond portfolio are as follows: average maturity of 6.5 years, yield to maturity of 3.63% and a modified duration of 5.507.

In sum, the asset and currency allocation in BL-Global Flexible currently looks like this:

A defensive investment strategy

2009-07-06T18:36:22+02:00

The first two quarters of 2009 couldn’t have been more different on the financial markets. While investors exhibited strong risk aversion in the first quarter, the second quarter saw the very same investors return to equities and high yield bonds. The stock markets reflected this renewed interest, recording their best quarterly performance in many years: after shedding 24% between 1 January and 9 March, the MSCI World went on to gain 47% between 9 March and 2 June. Since then, the index has remained stagnant.

In terms of investment strategy, the asset classes an investor should have owned differed fundamentally during these periods. For the first two months of the year, the optimal strategy would have been to give priority to defensive over cyclical companies in equity portfolios (or to get out of equities completely), prefer government bonds over high yield bonds in fixed income portfolios, and the dollar over the euro in terms of currencies. Starting in mid-March, an investor would have been well-advised to return to equities (in particular cyclical and commodities-related stocks), avoid government bonds and buy euros.

Investors’ readiness to move back into risky assets again was encouraged by what the markets are calling “green shoots” of recovery. Indeed, in the past few months many analysts seem to have made a pastime of hunting down indicators to confirm these green shoots.

An investor should always have an idea of the economic scenario priced into stocks and bonds. In March, stock prices were factoring in a scenario of continued deterioration in the economic situation, today they are factoring in a sharp recovery in company profits. Consequently, at the start of March, it was enough for news to be just that little bit less bad than expected for prices to rise. However, it will take more than that for a sustainable rise in stock prices to continue in the second half of the year and there will need to be more tangible signs of recovery.

I have already explained why I believe that the conditions required for a sustainable economic recovery in the industrialised countries are not in place. The two players whose ever-increasing recourse to debt had inflated growth in recent years, namely the US consumer and the banking sector, have begun a process of deleveraging that will last many years. Currently, there is nothing to replace these players as the engine of world economic growth. Recent data from China is encouraging, but Asia's transition from export-led to internal demand-driven growth will take some time.

The ‘green shoots’ that analysts seem to be able to detect are mostly indicators showing that the pace of economic deceleration is slowing down. The slump in activity following the collapse of Lehman Brothers investment bank was dramatic as illustrated by first quarter 2008 and first quarter 2009 data, and it was quite simply unthinkable that the world economy could continue to deteriorate at this pace. Data apparently pointing to imminent economic recovery should be interpreted in this light. It could be that economic activity has (temporarily) bottomed out, but there is nothing in the latest economic data to suggest that we are moving towards a sustainable recovery (it is important to emphasise the “sustainable”). It is possible that the rebuilding of inventories predicted by many analysts could temporarily boost growth. Unless final demand picks up, the phenomenon will be short-lived, however.

In my opinion, expectations of a strong durable recovery increasingly priced in by the markets will be disappointed. If this were the case, the ideal portfolio for the second half of the year, would resemble that of the first quarter. It would have a defensive orientation in terms of the overall asset allocation (lowering the equity weighting) as well as within each asset class (defensive stocks over cyclical stocks, government bonds over high yield bonds, dollar over euro). The main threat of such a defensive strategy is that risky assets will continue to benefit from a liquidity effect. Investing in equities for fears of underperforming an index, or because the return on money-market investments is weak, is not a good idea when fundamentals are weak, however.

S&P 500	600	700	800	900	1000	1100	1200
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Guy Wagner: Financial markets news and analysis

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Our strategy

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Our strategy

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Investment strategy 2011 (third part)

Investment strategy 2011 (second part)

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Presentation BL-Global Flexible

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Analysis of the situation in ten points

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Some thoughts for the summer (2):
Interpreting the increase in the price of gold