WILLIAM DE VIJLDER Blog - in English

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