WILLIAM DE VIJLDER Blog - in English

Difficult period of the year

Published in Moneytalk (Belgium) on 12 May 2012 

It is May, and that means investors’ thoughts automatically turn to the old adage of ‘sell in May and go away’. I’ve always had some problems accepting this advice because stock markets don’t follow a deterministic pattern. And is this ‘investor’s wisdom’ actually borne out by the figures? The following chart shows average monthly price movements (excluding dividends, therefore) on the S&P index over the past 10, 20, 30 and 40 years, based on the Robert Shiller database.

One thing that stands out is that monthly returns have fluctuated more over the past ten years than previously, whereas the patterns in the averages over the past 20, 30 and 40 years are far more in line with each other. The most recent period, therefore, has been highly atypical. There has also been some value in the ‘sell in May’ adage in the past ten years as the returns turned out negative. Although the picture over a longer period is less pronounced, returns during the summer months have nevertheless been lower than those at other times of the year. In other words, there is certainly a seasonal effect. It is not, however, that May in particular is a difficult month, but rather the whole period from June to the end of October. Literally deciding to sell your investments at the start of May would seem somewhat premature, therefore. Interestingly enough, I heard an analyst on CNBC say last week that this year the ‘sell in May’ advice would not apply until June. This immediately focused attention on the fact that ‘sell in May’ is not a law in itself, and that we need therefore to look at possible catalysts for price corrections. Memories of the past two years are still fresh, with regular fears of a new recession in the USA and another new phase in the euro crisis. Given developments in recent days in Spain and Greece, the situation in the eurozone – not surprisingly – is currently the prime candidate for putting investors’ nerves to the test. In the case of Spain I expect the storm created by the government’s support for the banks to blow over, if only because pressure from Europe, to name just one example, means the government is keen to achieve progress in this area. And achieving this progress is vital if international investors are to be persuaded to trust Spain again. Greece, however, is a source of greater anxiety, with the prospect of new elections (which would be held on 17 June and would de facto be a referendum on membership of the euro) against a background of austerity fatigue and the state’s empty coffers. That means at least another four weeks of uncertainty ahead, and we can only hope that, second time around, the result will allow the country to form a government without too much delay.

A second area investors are focusing on is the USA. There, the picture is clearly an improvement on last year, with no talk of a ‘double dip’. Economic growth is reasonable, while housing market activity seems (finally) to have turned a corner and to be moving in the right direction. Corporate earnings, too, are rising, while margins are good, and the Federal Reserve is continuing to operate very flexible policies and is on standby for QE3 if the stormy weather returns. The big question, however, will come after the Presidential elections: in other words, is the US finally going to do something about its budget deficit without choking off growth?

A third ‘hot topic’ is China, where growth in industrial production is slowing, but where inflation, too, is falling and so creating scope for more a flexible monetary policy via the banks’ reserve requirements. The most likely scenario for the Chinese economy would seem to be a soft landing.

To conclude, the financial markets’ summer is likely to be dominated by developments in Europe and, therefore, by a great deal of uncertainty. Although much of this uncertainty has already been discounted in prices (just look at the price/earnings ratios or dividend yields, which are around three times as high as German ten-year yields!), investors are still waiting for the ‘all clear’ signal. And that means we are set to continue in the ‘risk on/risk off’ environment, with rapid switching between equities and safer assets for quite some time to come.

William De Vijlder

Chief Investment Officer, Strategy & Partners

BNP Paribas Investment Partners

Making sense of RoRo

Published in Les Echos (France) and Le Jeudi (Luxembourg) on 25 April 2012.

After the euphoria early this year thanks to the long-term refinancing operations (LTROs) of the ECB, doubts about the Chinese economy, but above all about the Eurozone, once again gained the upper hand. Not only did the old doom-and-gloom scenarios about the Eurozone re-emerge, but so did the associated, somewhat time-weary, metaphor about ‘the marriage that is ripe for divorce’. As for the latter, let me make one thing entirely clear: that comparison is really unfortunate, because it completely ignores the huge cost of such an operation. What’s more, the comparison is exaggerated, because it underestimates the determination of the political leaders to reach a sustainable solution as well as the scale of the financial apparatus that has already been put in place for this purpose. As for the doom-and-gloom scenarios, in the really dark days, people tend to feel that ‘things can only get worse’, as if we were in an out-of-control train hurtling towards a ravine. Time and again, there are calls for a new LTRO or even unlimited bond purchasing by the ECB (the famous bazooka). Reality is different, however, and days of pessimism alternate with renewed optimism or perhaps simply indifference to the challenges facing the Eurozone. This illustrates the RoRo mentality of the markets (‘risk on/risk off’) and the related extremely short investment horizons (a few days), at least of certain investors. The reaction of others (I fear) is ‘I have had enough’: with them, RoRo leads to a complete ‘switch off’, just like in the old days, before the advent of ‘video on demand’, frustrated viewers would switch off the TV when there was nothing interesting on the box.

This RoRo world also reduces the probability of a new LTRO any time soon. Why should the ECB dip into its stocks of ammunition if markets react like a manic-depressive person? Take Tuesday 18 April, for instance. The Eurostoxx received a powerful impulse after the Spanish auction of short-term paper. So was it such a roaring success? No, though both optimists and pessimists found arguments to justify their views; the former because demand was extremely high compared to supply, the latter because the interest rate was a good deal higher than at the previous auction and because the large demand could be interpreted as a sign that investors were shifting their preference to the short end of the curve at the expense of the long end. The optimists won the day and the stock exchange moved higher. But it could just as easily have gone the other way.

Is it possible to rationalise such a RoRo market environment? Yes, because it illustrates the age-old combination of fear and greed – which is precisely the combination that creates bubbles (a centuries-old recurrent phenomenon) and unbridled panic (which is equally recurrent). Perhaps ‘fear and frustration’ is a more fitting description of the situation today; fear that ‘this crisis can go much further’ and frustration about the negative real interest rates. Interestingly, it is this frustration that adds a bright note to the RoRo world, because it limits the danger of a protracted downward trend: in view of the negative real interest rates, investors end up deciding to take some risk after all. And if the decline were to last too long, then the central bankers would ultimately add fuel to that frustration by printing more money.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners

Visualising the risk on trade using beta slopes for a new approach of assessing risk on/off in markets

Fears of US bond bear market are premature

Published in Moneytalk (Belgium) on 23 March 2012 and in Le Jeudi (Luxembourg) on 4 April 2012.

The recent improvement in the US economic data is unmistakable, though Ben Bernanke continues to adopt a cautious tone, evidently wary of counting his chickens before they hatch. This caution also reflects his concern not to alarm investors with any suggestions that the Fed’s first interest rate rise may come much earlier than the promised date of end of 2014. This, however, does not alter the fact that long-term interest rates have recently risen quite considerably. The rise since this year’s low in late January is already 40 basis points, sufficient to spark comments that the bear market in bonds has already started. This question matters for numerous reasons. Not-so-young investors will remember the bond crash of 1994 and that’s enough to make anyone nervous. What’s more, higher US interest rates dampen the investor’s tendency to seek his fortunes (= return) far beyond the borders, which could depress emerging country equities and bonds. The question is also relevant for Europe: there is a strong historical correlation between the movement of US and German long-term interest rates. And, given the weak economy in the Eurozone and the latent nervousness about a resurgence of the crisis atmosphere, an increase in these long-term rates is the last thing we need.

But are fears of a possible increase in US long-term interest rates justified at this stage? For various reasons, the answer is a clear “no”. As long as the Fed makes no moves to hike the policy rate, the current steep yield puts an upper limit on the potential increase in long-term interest rates: the short-term interest rate is about zero, so a person who invests in short-term paper instead of a ten-year bond has an opportunity cost of about 2% (the bond coupon). Short-term investing, therefore, is only rational if the investor thinks that the price loss on the bond will neutralise the higher coupon. Long-term interest rates would have to rise by about 20 basis points in the coming twelve months to break even between staying in cash for the coming year and investing in bonds today (due to the duration effect, the assumed interest rate increase would cause a price loss on the bond that would neutralise the coupon). In addition, in view of the interest rate increase that has already occurred, an additional rise would only take place if the Fed were to make noises pointing to a policy tightening towards the spring of 2013. This seems unlikely. A second reason is that, despite signs of improvement, the economy is still far from strong. Unemployment remains stubbornly high, the housing market is barely bottoming out, and the confidence of SMEs and households is still far below the pre-crisis levels. Important trading partners of the US (China and Europe) have, respectively, a decelerating and a weak economy. The third, and possibly most important, reason is that we must prepare for substantial budget cuts in the US once the presidential elections are behind us. Budget cuts would be positive for the bond market as the slower accumulation of debt (due to the smaller deficits) will mean less nervousness among investors, leading to lower interest rates. Moreover, a relaxed monetary policy could help to compensate the negative growth impact of the budgetary restructuring. So the signs for next year are that the US will adopt the same policy mix of monetary relaxation and budgetary tightening currently applied in the UK under prime minister Cameron.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners

Factor approach to investment brings greater correlation

Published in l’Agefi (Switzerland) on 27 March 2012 and in Beleggers Belangen (Netherlands) on 27 March 2012. 

The stock markets have been extraordinarily buoyant since the start of the year. For January/February, we have to go back to 1991 to find a higher excess return on the MSCI World index compared with US Treasury bills. Many other asset classes also turned in good or excellent performances: corporate bonds, emerging market bonds, emerging market currencies, commodities etc. There was clearly a 'risk-on' environment, supported by liquidity creation (the ECB’s LTRO), and an impression that the economic situation is getting slightly better, with the US economy leading the way. 

The problem is that if ‘everything’ is rising in price, the correlations are high. As we know, there is no such thing as a free lunch: when someone invites you, they always have ulterior motives... For a long time economists regarded portfolio diversification as the only exception. The idea was that a judicious combination of different asset classes ensures a higher return per unit of risk. But this perception was seriously shaken during the financial crisis in 2008. At that time, the correlation between different investments increased sharply, prompting the somewhat cynical comment that diversification is something you have when you don’t need it (when volatility is low), but lose quickly when the pressure on the markets intensifies. The situation has not really improved since 2008, and the chart below suggests that even this free lunch is threatened with extinction. After all, since 2002 we can observe a steady rise in the average correlation among a wide range of asset classes, and recently the correlations have exceeded the spikes of 2008.

Source: BNP Paribas Investment Partners

There are several explanations for this development. One factor is the low interest rates compared with the returns sought by investors. In such a situation, investors will be tempted to respond to every return opportunity that presents itself, including short-term market movements, on the principle that every basis point of return helps. A second explanation is the shortening of the decision horizon, which means that even long-term investors take decisions for shorter periods, which they reverse, if necessary, at a later stage. This may suggest that they are less certain about the long-term forecasts and expectations, so they decide to play a shorter game. And thirdly, there is the growing popularity of instruments that enable very active investing. Exchange-trade funds (ETFs) spring to mind here. In the past, highly dynamic investment was only open to professionals via futures; now everyone has that opportunity via ETFs. 

These explanations actually provide more of an answer to the question of why volatility has increased, not why the correlation between asset classes has increased. One explanation for the stronger correlation is that these days, more than in the past, the shocks are global rather than country-specific. Shocks with a ‘local’ origin (e.g. the US housing crisis) will have a global impact through contagion. The same is true for the eurozone crisis. Here, too, the impact has gone far beyond the European Union, owing to a reduced risk appetite among investors, fears of a Europe-wide recession with negative implications for trade partners, and so on. 

The higher frequency of shocks provides a second explanation. Correlations increase when shocks occur. The above chart shows that there have been three shocks since 2008: 2008 itself (the financial crisis) and then 2010 and 2011 (the eurozone crisis in both cases), while the years between 2004-2008 were a relatively calm period. (Incidentally, the impact of shocks is accentuated on the chart because it uses a rolling average.) Once a shock has passed, the correlations weaken again, but when another shock occurs, they increase. More frequent shocks push up the average correlation. 

A third explanation involves an improved understanding of the behaviour of asset classes. We can call this the ‘generalised factor approach’. Equities provide exposure to an interest rate factor and a growth factor. High-yield corporate bonds do the same, which is why they show a close correlation with equities. Emerging market bonds have a domestic interest rate factor, an international (i.e. US) interest rate factor and a ‘global economic cycle’ factor (in short, optimism about growth generates more interest in these investments). The intensity with which these asset classes are exposed to the above factors will vary of course, but this does explain why even in bond portfolios, growth-sensitive bond categories perform better when confidence is growing. 

If investors are convinced they have a grip on these themes, then investing will become more and more a case of ‘surfing on beta waves’. That is to say, at one point the growth theme will dominate, and investments that rely heavily on this factor will increase in price; then another theme (inflation, monetary policy etc.) will come to dominate, and other investments will top the performance league. What matters for investors is to decide for each investment from their universe what factors are relevant and how strong a factor’s impact will be. Then they must decide which factor will be the focus of attention (‘what’s hot, what’s not’). The extent to which this factor is associated with economic growth will determine the markets’ risk-on or risk-off behaviour. Incidentally, momentum investing may enhance this phenomenon. In this situation, investors will buy an instrument because of its beta characteristics rather than any fundamental changes in the asset class. All this is then rationalised by arguing that risk appetite has increased or decreased... 

Going back to the chart, I would like to make two further comments. As the correlations surge, the chance increases that they will weaken again. In the past weeks the correlations have strengthened considerably, so we can assume that they will weaken again in due course. We can also see that the average correlations will weaken for a considerable time once the correlation spike has passed. Diversification will then re-emerge, but more than in the past, the behaviour of the various asset classes will be determined by several different factors. Investing will become more fascinating, because the single-factor approach will be less successful, but it will also be more difficult because many more data will need to be analysed. Still, that will be worth it, if only because diversification will be more effective. 

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners

Should inflation be feared as a result of unconventional monetary policies?

Text published in Beleggers Belangen on 9 March 2012

Will the ECB’s long-term refinancing operations (LTRO’s) create inflation? Yes, certainly… inflation in the number of articles on this subject. On 29 February, the day on which the European Central Bank launched its second LTRO operation (the first took place last December), Twitter was flooded by a tsunami of messages. They were mostly very critical and maintained that it “was encouraging speculation”, “creating a bubble”, etc. This negative viewpoint is astonishing. Where would we be today if the ECB had not implemented this courageous policy in December, thereby putting an end to the vicious circle going from public finances to increased financing costs, to the banking system, to economic activity, and back to public finances? Would the economic sentiment surveys be at the same level as at present? This is a rhetorical question. Nevertheless, a former director of the Dutch central bank sent a tweet posing the very relevant question of how to eventually drain more than one thousand billion euros of liquidity from the system. This will be a crucial question for financial markets in 2013 and 2014, and a similar debate is raging in the United States.

Regarding LTRO 1 and 2, it is important to distinguish between three phases. The first one, which is behind us, involved stopping the vicious circle described above. The second one aims to improve the operation of the mechanisms of monetary policy transmission by lowering the interest rates at which euro-zone governments obtain financing, reducing uncertainty and restoring confidence, all this with a view to a pickup in economic activity. This process takes time, but the financial markets anticipate it, which explains stock markets' exuberance in January and February. The rise in equity markets and in the prices of corporate bonds (and hence a fall in their financing costs) are therefore not the sign of a resurgence of speculation, but reflect a certain revival of risk appetite on the part of investors, which is a necessary and beneficial stage in this process of recovery. The third phase will aim at gradually draining the exceptional liquidity that has recently been injected into the economic system. This will be a necessary exercise, failing which there could be extraordinary growth in credit volumes followed by an acceleration of inflation.

It is important to qualify these two aspects. Regarding credit volumes, everything depends on the private sector's will to leverage further and on the banking sector's will to grant credit. These two behaviours are pro-cyclical: when activity picks up, credit demand and supply increase. Given the current excess reserves in the European and US banking systems, there is a fear that an increase in credit demand could lead to a sudden, sharp increase in the volume of credit in the economy, since reserves are there to respond to the increase in demand. In such a scenario, the central bank would risk losing control of the money supply.

Inflation, for its part, could appear following an acceleration in the volume of credit, but the risk, at least in the short term, seems limited. Unemployment in those countries/regions that have adopted unconventional monetary policies is and will remain high (just consider the long-term forecasts of the Federal Reserve, for example), so there will be no rapid resurgence of bottlenecks. However, monetary creation inevitably leads to more inflation: Without being a monetarist, Friedmanite theory teaches us that this type of operation drives up asset prices and the general price level. The theory is of course more complex, as is the reality. Monetary creation can, in particular, be absorbed by a fall in the velocity of circulation of money, or by a rise in the prices of certain assets (stock markets, real estate), thus limiting the risk of acceleration of "real" inflation, i.e. inflation in goods and services. Flight to the rest of the world is another important factor and can reduce the risk of domestic inflation. We note that analyses of quantitative easing policy are too often based on a closed economy. Now, we live in a globalised economy, where monetary creation in low-growth countries results in capital flows to emerging countries which have sounder economic fundamentals. These countries typically have a high level of capacity utilisation, close to or even above normal. Capital inflows push up the prices of financial assets there, which is equivalent to giving a boost to an economy that is already humming along. Unless currencies soar (cf. the 2010 debate over the “currency war”), we can conclude from this that monetary creation will more rapidly create inflation in emerging countries than in the countries with an unconventional monetary policy. This point, moreover, was raised recently by John Authers in the Financial Times, and I share his viewpoint.

Inflation in emerging countries will take the form of a rise in commodity prices, for example, or a rise in the cost of labour, and it is via this channel (commodities, import prices) that developed countries will experience an acceleration of inflation while at the same time having a high level of unemployment. Accordingly, investors should be prepared for a change of regime. In this new era appearing on the horizon, central banks will gradually prepare their exit strategy (this concept had already appeared, prematurely, in 2010), namely a return to a normal monetary policy to prevent a structural rise in inflation and hence the loss of their credibility. This transition poses several challenges for central banks (how to prevent the long end of the yield curve soaring as in the 1994 bond crash?), but also for investors. For the latter, the normalisation of monetary policy implies that attention will now be focused on a detailed analysis of companies' cash flows, an exercise that is far more difficult than managing expectations of monetary bazookas.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners

How much should investors swim against the tide?

Despite all the negative comments at the end of 2011, the financial markets have surprised investors positively so far this year. There is a strong temptation to argue that investors should always go against the prevailing mood: buy when all the news is bad, and sell when everyone is optimistic. Reality is of course more complex, but it is clear that investors have to judge a theme’s “eat by date”: when bad news is gripping the markets, they should watch out for the ray of sunshine piercing the clouds, because this may be the prelude to a brighter period; and conversely, when the sky is blue, they should try to find out where the first clouds might come from.

How much should investors swim against the tide, as it were? Recent reports suggest that the glass is at least half-full for investors. The US labour market is finally improving; confidence indicators in Europe seem to be stabilising; the Chinese authorities have relaxed the capital reserve requirements for banks; the income tax cut introduced under the Bush administration has been extended; an agreement has been reached on Greece. When I saw the headline on the front page of last Saturday’s Financial Times (“S&P gains hint at budding recovery”), I couldn’t help but feel that it’s time to start looking for what could eventually turn the current positive sentiment around. Five possible factors spring to mind. One, the upswing in the equity markets. The Eurostoxx-50 has gained around 10% since the year start, and the S&P-500 around 8%. And several emerging country share indices are performing much better than that. Many investors have already gained more from their equity investments than they expected for the whole year, so the longer this upswing continues, the greater the temptation to secure part of the profit. Two, the economic figures. In the United States, these – including the labour market – are clearly heading in the right direction, and on top of that the construction sector seems to be recovering as well. In Europe the confidence indicators have turned out better than expected. The better the results, the more difficult it becomes to surprise economists positively, and disappointing data would of course undermine investor sentiment. Three, the elections in Greece. Due to be held in April, they are in danger of being completely dominated by the theme of the country’s economic and financial situation and the policies pursued to deal with it. Four, a rise in the oil price. In dollar terms Brent oil has reached the 120 mark, and in euro terms it’s trading at the 2008 peak levels. This of course has to do with the geopolitical risks (Iran), a factor which is not likely to fade into the background any time soon. A further hike in the oil price, for political reasons or for instance also in anticipation of the world economy performing slightly better in the second half year, could eventually become a serious problem, for the central banks (fueling inflation fears) and for the growth outlook. Five, a renewed focus on the major structural challenges, both in Europe and the United States, with the upshot that growth forecasts remain modest by historical standards.

The point for investors is to assess when one or more of these five factors gain in importance. For now the surfeit of liquidities dominates everything, and it is these which are supporting share prices indirectly; but let’s not forget about the “eat by date” argument.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners

Surfing a wave of liquidities

For several months now I have been a fervent Twitter user. I can send brief messages (available at #DeVijlder), but above all I appreciate the medium as a very fast source of information. Some twitterers are particularly ironic, if not cynical. Today (1 February) there was an exchange of song titles meant to typify the current European climate (#eurosong). The performance of the financial markets in January might suggest “Alors on danse” (Stromae), or perhaps even better “Against All Odds” (Phil Collins), because against all expectations – remember the doom and gloom at the end of 2011 – January brought some fireworks with surging equity and corporate bond prices and a buoyant gold price (people are “sniffing” inflation over the long term).

Commentators offer many explanations. Monetary policies in the emerging countries are expected to ease; higher-risk investments (equities, corporate bonds, emerging market debt) offer attractive valuations; macro-economic data have proved better than expected. On the back of the purchasing manager indices (PMIs) published today, Reuters has calculated that the economies of the majority of countries or regions (10 out of 15) picked up compared with December, and that 10 out of 15 are still in expansionary phases (with PMIs above 50). The countries in the “sweet spot” (i.e. a PMI above 50 and rising) include heavyweights such as the United States, Germany, Japan, Brazil, India, Australia and the United Kingdom.

However, the driving force behind the upbeat mood is money, bucketloads of money. The Fed, the US central bank, has announced that it will keep the federal funds rate unchanged through late 2014, and in doing so has effectively invited US investors to take more risk. The ECB has introduced a form of quantitative easing with its 3-year refinancing operation (LTRO). The idea underlying this operation, and hence its strength, is that it aims to put a stop to the negative feedback loop from the sovereign debt crisis via the banking system to economic activity. Banks now find it easier to raise funds, and some South European banks have already secured their funding needs for the whole year via the LTRO. Later this month there will be another 3-year LTRO. No doubt the banks will again borrow large amounts, which will boost risk appetite.

In short, investors are less worried about the systemic risk, and are also anticipating an improvement in the real economy. For now this is still more wishful thinking than reality, and if there is some economic upswing it is happening from a very low level (in the United States, for instance). Unemployment in some European countries has reached unprecedented levels (and youth unemployment is even higher), and on top of that fiscal policy will have to be tightened further. So this rally is different from that in March 2009. This also started on the back of marginal signs of improvement (upbeat reports from some US banks), but valuations were cheaper then, we were in recession, so things could pick up, there was still potential for stimulating the economy, and the eurozone was still a region of relative calm. The situation is rather different now. We find ourselves in a liquidity-driven rally, reflecting the saying that “a rising tide lifts all boats”. I remain of the view that investors with long horizons can afford to expose themselves to a bit more risk if they are mostly in cash at the moment. But tactical equity investors should focus on what might dampen the enthusiasm. Such factors include disappointing macro-economic data from the United States or China, and, in the case of Europe, developments in Greece and … Portugal.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners

William De Vijlder comments live on Reuters Insider

Topics include developments in Greece and the investment strategy in the current environment

William De Vijlder, CIO Strategy & Partners at BNP Paribas Investment Partners, gave his current views on the latest developments in the Greek sovereign debt crisis and other catalysts for financial markets together with the implications for investors live on the Reuters Insider channel on 9 February. To see the video, click here.

Investing in RRR: return at reasonable risk

Many equity investors use the GARP style: growth at a reasonable price. This involves looking for attractively priced (i.e. not too expensive) equities with earnings growth that consistently exceeds the market average. However, the time has come to talk about a new investment style: RRR or return at reasonable risk. After all, these days the emphasis in the investment community is on risk assessment. As always happens in lean economic times and during periods of uncertainty, ‘risk’ is equated with the ‘chance of considerable capital loss over the short term’. Despite the recent upswing in equity prices, investors remain very wary of such a risk. This explains why the safe havens (German Bunds and US Treasuries) are expensive, with 10-year yields below expected inflation over the same period. And in the shorter segments, German nominal returns are actually negative. If inflation is deducted, the real return is quite negative.

Financial repression

A situation like this is a kind of financial repression, albeit not imposed by a government in the form of investment obligations. On the contrary, it is a self-imposed type of repression. Theoretically, this could be qualified as irrational behaviour, but when risk aversion is extremely high and capital protection is investors’ main concern, such behaviour can be perfectively rational. Any alternative investments will be considered too risky because of the duration risk, bad debt risk, counterparty risk, equity price risk, currency risk etc. Therefore, instruments that are not or only minimally exposed to these risks become very expensive and offer very low returns. The price of avoiding all such risks is to pay the ‘inflation tax’. Given a choice between a certain, though slight, erosion of the real value of capital and the possibility of a larger loss (but also a gain!), risk-averse investors will go for the certainty offered by the first option.

Negative carry

However, this rational attitude only has a limited shelflife, because most investors must achieve a particular real return. A majority of working people are saving for a good pension, and this requires the accumulation of real capital through saving and realising positive real returns. The latter, in other words, represent the target return. Investing at negative real returns creates a situation of negative “carry”: the portfolio yields a negative return after inflation of, say, -1% while the target return is +3% after inflation. Every year that yields such an outcome translates into a 4% underperformance compared with the plan to ensure a sufficient pension pot on retirement.

How to avoid financial repression and negative carry?

The easy answer to this question is to take more risk. Of course this would entail a complete denial of the investment principle, which is high risk aversion. So the aim should be to search for a return at a reasonable, acceptable risk. For two reasons this immediately raises the question of the investment horizon. Firstly, as the period of an investment that involves some degree of risk is extended, the annualised risk will decline. This is because good and bad times tend to cancel each other out to some extent. Holding shares for one year carries substantial chances of either very negative or very positive returns. After two years, these chances are still high, but already somewhat smaller, and after ten years they are much smaller still. This phenomenon is called time diversification, and constitutes an argument in favour of long investment horizons. But it has a downside, and that is the second point which gives relevance to the horizon discussion. In the case of a long horizon, it is important to invest in instruments that offer sufficient protection against inflation (read: sufficient positive real return), or in instruments whose return will rise in line with inflation. Against the background of the current extremely low risk-free yields (i.e. those of the safe havens) and the most likely resurgence of inflation over the somewhat longer term − owing to the central banks’ ultra loose monetary policies − it is essential to realise that nominal bonds do not provide the required protection because of the low to negative real interest rates.

So how do risk-averse long-term investors looking for return deal with this inflation risk? There are several options:
1. Take very short duration positions, in the hope that the central banks will raise their base rates quickly enough if inflation picks up. Investors who choose this option are willing to accept negative returns over the short term, in the belief that returns will eventually rise and everything will work out fine. I fear that such an attitude could bring disappointment. Central banks are actually counting on negative real policy rates to stimulate their economies, and they will not be terribly keen to raise rates if inflation accelerates.
2. Take very long duration positions. The problem here is that the durations must be very long to gain at least a limited compensation for the huge duration risk. A 10-year German Bund has a duration of around 9, which means that an interest rate hike of 100 basis points will depress the market value by 9%. And a 30-year Bund would fall by 20%! The limited compensation also means that the protection against higher inflation is very modest.
3. Invest in inflation-indexed bonds denominated in euros. The break-even inflation rate (i.e. the future inflation rate at which it no longer matters to investors whether they buy nominal or index-linked bonds) is around 2-2.5%, which implies that the real coupon is currently negative. This is an unfortunate circumstance, but an indexed bond will protect against inflation climbing above the current break-even level. Still, investors will have to be patient. In an economy on the brink of recession, inflation will not pick up immediately.
4. Invest in inflation-indexed bonds in USD, CAD, AUD and GBP. While the break-even levels for these bonds are not that different from those in the eurozone, inflation in these countries could pick up sooner. Meanwhile, their central banks are taking more risks and/or their economies are in better shape. This kind of investment involves a currency risk, of course, which will require very active hedging.
5. Take credit risk to jack up the real return, which also provides a buffer against inflation. Certainly from a buy-and-hold approach (i.e. keeping bonds until maturity), investors currently find themselves in a very intriguing environment provided they do their homework (creditworthiness analysis). The investment-grade index in euros offers a spread (i.e. additional return) of 275 basis points (yield of 4.0%) on Bunds with an equivalent duration; excluding banks, the spread is 164 basis points (yield of 3.1%). The high-yield index in euros offers a spread of 915 basis points (10.4%). It goes without saying that a rigorous selection is required, but there are certainly opportunities.
6. Invest in emerging market bonds. In USD terms (i.e., external debt) the yield on these bonds is 6.08% with a duration of 11 years. So yields are appreciably higher compared to US Treasuries for an index with an average rating of BBB-. In local currency terms – not recommended for individual investors– the yield is 6.85% for a much shorter duration (6.7 years). Emerging market corporate bonds offer an attractive additional return over western corporate bonds in the same rating category, as shown in the table below (issues in USD).

What about equities?

The search for additional return may tempt investors to buy corporate bonds at coupons below the dividend yield. Provided that the company in question has a healthy balance sheet, this approach can be regarded as rational for risk-averse investors given their fear of equity price risk whereas they have a sense of security about the credit risk and expect to recoup their initial investment on maturity.

Risk-averse investors avoid equities because of the short-term risk or their doubts about the return over the long term. The first type of risk can be addressed by spreading purchases over time and avoiding purchases when equities are very expensive. But what about the second type of risk, a much more sensitive issue in light of the experiences of the past decade? This depends on dividend yields and equity price movements. A high dividend yield means that a cushion can be built up over a number of years: even when equity prices are down, the accumulated dividends can provide some compensation. The table below shows the dividend yield of the European share indices, which is appreciably higher than the yield on 10-year government bonds. It illustrates how cheap equities are relative to government bonds.

 

The yield on a Belgian government bond is around 4%. So an additional yield of around 1% per year will produce a ‘cushion’ of just over 10% after 10 years. In the case of German or French government bonds, this dividend ‘cushion’ produced by investing in equities is even greater. In comparison with German government bonds, it can climb to 30%. So what does this cushion mean specifically from a cash flow perspective within the portfolio? Assuming the dividend paid in euros will not fall, the European share price index could decline by 30% over 10 years to achieve the same return as the yield on a 10-year German Bund over that same period. What is more, if inflation rises, the dividend payment − which is a nominal variable − will increase; this is not the case for bond coupons, which have been fixed for the bond’s term.

Questions from pessimistic investors

Pessimistic investors may well argue that dividends can fall. This is true, which is why the selection of stock within the current high-dividend universe must be made very carefully. This avoids ‘value traps’, when the high return flows from a sharp equity price fall because the market doubts the sustainability of the dividend policy.

Pessimistic investors may also decide that equity prices will not rise at all. In principle this is an interesting line of argument, given that real economic growth is usually positive, that inflation is also positive, and that there is a close correlation between nominal earnings growth and nominal GDP growth. What would be the outcome of an extreme hypothesis of unchanged equity prices over the next 10 years? Let us assume that nominal earnings growth is 2% per year over the coming decade (this implies zero to slightly negative annual earnings growth in real terms). If this earnings growth is not translated into equity price gains, the price/earnings ratio will have fallen by around 20% in a decade. This would be equivalent to levels of around 7.5! It is worth noting that under an unchanged dividend policy, this also means that the amounts paid out in dividends and the dividend yields would rise year-on-year. The dividend yield, which already exceeds the bond yield, would then come out appreciably higher. In short, such a scenario is only realistic if one believes that the western world, and Europe in particular, is heading in the same direction as Japan. If not, it is safe to assume that 10 years from now equity prices will not be lower than today.

Pessimistic investors may point out that these are all theoretical considerations and that we should look at historical experiences as well. What does history teach us? The chart below shows the development of the Dow Jones share index in the United States. (I have used this index because of the length of the available time series.)

 

Since 1910, there have been 103 10-year periods. On 20 occasions, the index was lower at the end of the 10-year period than at the start (see table). This figure is on the high side because a stock market crash tends to reverberate for a long time; that is to say, it impacts on many observations of the moving 10-year average.

 

The instances of negative 10-year equity price changes are concentrated in the early part of the 20th century (First World War) and during the depression of the 1930s. We saw a similar pattern after the first oil price shock as well as more recently (in 2008 and 2009). In other words, overvaluations (1929, late 1990s) or big shocks (oil in 1974) significantly raise the chances of lower equity prices 10 years later. I cannot comment on shocks, but the current valuations are no obstacle for long-term investors considering moving into equities.

Conclusion

Investors are risk-averse at the moment, which is understandable. But given the negative real interest rates over the short term, and in the case of the safe havens even over the long term, it is still necessary to look for investments offering higher returns . Due to the risk aversion, the emphasis must be on additional return at a reasonable risk. Corporate bonds and emerging market bonds offer the most interesting opportunities in this respect. Stocks of high-quality companies with attractive dividend yields are also worth considering from a return perspective. (I am not, however, commenting here on the equity price gain potential compared with equities with lower dividend yields.)

The key question involves timing. When investors are very risk-averse, the danger is that they keep delaying, which results in opportunity costs for those with long investment horizons. By waiting (due to fear of equity price losses over the short term), investors will not enjoy the higher returns. Meanwhile, the long horizon opens the door to an attitude that price losses will be followed by gains.

In short, the answer to the question of when to enter the market is as follows: (i) spread purchases over time, (ii) act like a real long-term investor (buy-and-hold, which does not necessarily mean passive portfolio management), and (iii) abandon the straitjacket of mark-to-market thinking.

William De Vijlder
Chief Investment Officer, Strategy & Partners
BNP Paribas Investment Partners
26 January 2012