WILLIAM DE VIJLDER Blog - in English

LTRO adds to pent-up demand for risky assets

What would have been the decline of European equities if the 3 year long term refinancing operation (LTRO) of the ECB would have seen a lukewarm response of banks?  I suppose significant considering that the enthusiastic response seen yesterday (EUR 489 billion taken up by 523 banks) only had a very short-lived positive impact on equity markets. Does this mean that the entire operation has been pointless from a market perspective? Not at all. Importantly, investors will have a more relaxed feeling about the considerable refinancing of bank paper that is due to take place next year. If investors would not reinvest all of the maturing paper, the banking sector liquidity needs would be met by the refinancing operation in December 2011 and a similar operation in February 2012. 

Admittedly, the LTRO does not address directly the financing of budget deficits of eurozone members although indirectly there is a link when banks use the liquidity provided to buy government paper which is then used as collateral for loans from the ECB. For that reason, a country like Spain had seen quite a decline in its 3 year bond yield after the announcement earlier this month that the 3 year LTRO would be organised. The key question is of course to what extent liquidity will indeed be used to buy government paper. We’ll have to wait and see. One should expect this will be function of the progress made in other areas and in particular on the new governance model agreed upon at the latest EU summit. The upcoming political summits will (again) be crucial.

Against the background of the negative comments in many analyses and articles on the absence of a bazooka (a highly leveraged EFSF, ECB as buyer of last resort), on the outcome of the most recent EU summit as well as on the LTRO (I’m referring to the negative equity market reaction), there is a risk of losing sight that gradually progress has been made:

1. The ECB has eased it policy (cut in the official interest rate; two 3 year LTROs; facilitating funding via covered bonds; reducing the reserve ratio from 2% to 1%; etc) which will give a considerable boost to liquidity (the reduction in the reserve ratio frees up EUR 100bn)
2. The firepower of the IMF is being increased
3. Governments have committed to a fiscal policy which will bring the structural deficit back to maximum 0,5% of nominal GDP. Automatic correction mechanisms are foreseen as well
4. The entry into force of the European Stability Mechanism has been accelerated and an emergency procedure for decision making has been introduced
5. The ECB has accepted to act as the agent of the EFSF which indicated the latter is getting ‘ready for action’

Clearly, there are still many uncertainties, notably on translating the new governance framework into legislation, and investors understandably adopt an attitude of ‘better be late than sorry’. Risk aversion comes with a price though, it is sufficient to compare the level of short term rates to inflation. The liquidity which has been put in the system via the first 3 year LTRO and the reserve ratio reduction and which will be complemented by the second 3 year LTRO (which probably will again be successful), in combination with an overweight of low  yielding low risk assets and safe havens create a huge pent-up demand for risky assets. The big question is when this will be unleashed. 2012 is about spotting this catalyst.

William De Vijlder
Chief Investment Officer, Strategy & Partners, BNP Paribas Investment Partners
22 December 2011

Three betas and an alpha: managing under uncertainty

Last week I participated in a panel debate organised by a Dutch financial magazine. It lasted about two hours and the word ‘uncertainty’ was used countless times and quite rightly so. What we are experiencing today is rather extraordinary and puts investors in an uncomfortable position. Historical reference points are lacking. In a normal business cycle, past behaviour of economic time series can give guidance for the future. The same holds for market ‘cycles’ (I use inverted kommas because I want to avoid creating an impression that these cycles are deterministic). Today, recovery is slow and there are recurrent worries about a re-lapse into recession. Monetary policy is ineffective thus far, hence QE2 and Operation Twist in the US. As far as market cycles are concerned, we seem to be in a permanent high volatility/high correlation regime where risky assets are priced off a ‘to be re-defined’ risk free rate of return. In summary, uncertainty is high. Referring to the great economist Frank Knight, in dealing with uncertainty we do not have reference points, statistical distributions are lacking and using the word ‘probability’ in assessing uncertain outcomes (as opposed to risky outcomes) is meaningless.

How do you deal with uncertainty as an investor? How do you handle a situation where traditional approaches and metrics become less reliable because the outcome can be completely different depending on the occurrence of some uncertain event? I differentiate between different behaviours.

1. caving in. This is the equivalent of hiding in a bomb shelter. One invests with a short horizon (to avoid interest rate risk) in a high quality deposit or in high quality treasury bills in the home currency. This is fine if real interest rates are positive but it is getting expensive when they are negative because of the opportunity cost of missing more attractive albeit riskier returns. Under extreme risk aversion, nominal short term rates on treasury bills can even become negative, as we have seen in Germany recently
2. diversifying. Always a good idea but the realisation of specific uncertain events can have a big impact on portfolios which a priori are well diversified. Diversification isn’t the all encompassing answer when correlations spike
3. use rules to cut your losses. This is about downside risk management. Stop-losses protect against the behavioural bias of ‘let’s hold on to the position because it’s too late to sell anyhow’. It does mean that these rules seek to protect against ‘further’ downside implying that the initial hit has already been taken
4. do more homework. Spending more time on analysis before deciding can be a good idea but it’s not a guarantee for success in dealing with uncertainty which by definition is unpredictable
5. work on portfolio construction. I will elaborate on this in the next paragraph.

Portfolio construction is about deciding which exposures to take in an investment portfolio. These exposures can be looked at from the angle of asset classes (this is the traditional approach: equities, bonds, commodities, etc) or from the risk factor angle (equity market risk, value versus growth exposure, small cap versus large cap exposure, credit risk exposure, yield curve exposure, etc). Whatever the angle, all of this can be put under one denominator: beta exposure. In addition, one can also have idiosyncratic exposure also known as alpha exposure based on convictions on individual stocks and issuers.

How can portfolio construction, i e allocating between alpha and beta, help in addressing uncertainty? Alpha can be particularly useful when market direction is completely unclear. In such an environment the expectation is for a low return and a wide range of possible outcomes (low return with high volatility). If one needs to have equity exposure because of strategic benchmark considerations (e g in case of pension funds, foundations or private investors with a long horizon), seeking to exploit alpha opportunities using active management is a good idea provided the skill is there. Realising an excess return will be all the more appreciated if the market return (beta return) is low. Alpha can even be useful in the absence of a strategic exposure to equities: the investor will then opportunistically allocate money to carefully selected equities seizing opportunities offered by markets which faced with uncertainty tend to overshoot.

What about beta in the portfolio construction? Here I distinguish between three betas:
1. traditional beta. This is the return offered by exposure to risk premia (equity risk, style risk, size risk, default risk, yield curve risk, etc). Ideally different exposures are taken simultaneously and in an intelligent way to exploit the imperfect correlation between the return streams. However, as mentioned above, diversification benefits go down when uncertainty spikes
2. smart beta. This concerns the pay-off for the exposure to a risk factor but whereby that exposure is taken in a ‘non-traditional’ way. In recent years an increasing number of approaches have been popularised which have a more attractive return/risk ratio than traditional capitalisation weighted benchmarks. In a world of increased uncertainty minimum variance and low volatility portfolios are particularly interesting because they offer low absolute volatility in combination with attractive returns and in the majority of cases they deliver superior returns to cap weighted portfolios
3. transformed beta. The return offered by exposure to risk premia is transformed either by applying rules (as explained above) or by investing in instruments with an a-symmetric pay-off (convertibles, hedge funds, capital guaranteed products, options)

In summary, dealing with uncertainty is extremely challenging because the traditional investment process reaches its limits, in other words markets become less predictable whatever the process (qualitative, quantitative) used to define the views. Combining three betas with alpha allows the investor to come a long way in addressing the challenges which the former US Secretary of Defense Donald Rumsfeld used to label as ‘the (un)known unknowns’.

William De Vijlder
Chief Investment Officer, Strategy & Partners, BNP Paribas Investment Partners
9 December 2011

2012: clouds, clouds and more clouds…with brief sunny spells

Everyone is familiar with the experience: you are on the beach and the sun that was shining so brightly has disappeared behind the clouds. You look up to see how fast the clouds are moving, hoping for a ray of sunshine. That is roughly what we can expect from the stock markets in 2012. The large dark cloud that has been hanging over the market for some time is that of the eurozone crisis. Let’s hope that the (umpteenth) crucial summit of 9 December will provide a bright spell. However, though very welcome, that will still not lead to permanent sunshine. The next cloud is already on its way: the recession in Europe. Looking at the Purchasing Manager Index (PMI), we are already in recession and next year the impact of the public spending cuts will also start to kick in (though we should note, of course, that the decline in confidence indicators like the PMI already partly reflects this development). Another factor to be taken into account is that a satisfactory answer to the eurozone crisis would remove the current reluctance among businesses and households to invest and consume. If growing uncertainty weighs down growth, as the IMF has ‘proven’ with hard figures, then a decrease in uncertainty should provide a positive impulse. Nevertheless, 2012 will be a difficult economic year and investors wonder what to make of the consensus forecast of 9% profit growth and 4% sales growth in Europe, which is above inflation. What’s more, margins are already very high. In the US more than 10% profit growth and 4% sales growth, as well as improving margins, are forecast. So this leaves no room for disappointing macro developments. The picture that emerges is one of jubilation if a solution to the eurozone crisis is found, followed by doubts about future profit growth. Assuming that the US economy manages to move up a gear thanks to Operation Twist or Quantitative Easing 3, a further short-lived bout of euphoria will soon make way for a renewed focus on the political uncertainty: if the Administration and Congress have a different political colour, the chances of getting the US back onto the straight budgetary track look slim. Yet another cloud.

So are there any places where the sunny spells may last a little longer? Certainly. US high-yield bonds are clearly cheap: the market is unduly negative about the economic developments. What’s more, the US will not slip into recession and the base interest rate remains extremely low, which will restrict the number of defaults. In addition, emerging market bonds (and particularly corporate bonds) are attractive, offering clearly higher yields than similar-quality bonds in the West. If you buy these bonds in local currency, you can also benefit from the upward potential of currencies that were recently hard hit by the global increase in risk aversion. Finally, emerging market equities are also an alternative worth considering. Though growth in these economies (e.g. China, India and Brazil) is also slowing down, this creates scope for monetary relaxation. Moreover, growth will remain substantial and the relative price/earnings ratio has decreased further versus western markets (the discount is even larger than normal). When the weather outlook is uncertain, holidaymakers tend to book flights to far-flung sunny destinations. That is certainly worth considering in the investment world.

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

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