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

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

Listening to Bernanke: how transparent should the Fed be?

(Opinion piece in De Tijd - 27 January 2012 - http://www.tijd.be/opinie)

Can transparency ever be too much of a good thing? That’s what I wonder when contemplating the Federal Reserve’s new communication policy. I’m not talking about the announcement on 25 January that the US central bank will keep its policy rate unchanged until late 2014, nor about the 2% inflation target. What I’m still struggling with is the publication of individual FOMC members’ long-term forecasts for the fed funds rate. For economists this publication is a godsend, and in a few years’ time postgraduate students will be eagerly writing up PhD theses. You can do a lot with these details: for instance, answering the following questions:
1. how has the average forecast of the first policy tightening evolved in terms of timing and size in comparison with the previous forecast?;
2. is there a correlation between this evolution and data published subsequently?;
3. is there a link between FOMC members’ speeches and individual forecasts (“who endorses which forecast?”);
4. do we need to worry when the individual forecasts range more widely?;
5. when there is a significant discrepancy between the average forecast and what Ben Bernanke says, does this mean that his credibility is at stake and that his position could be undermined?;
6. when the profile of the projected fed funds rate is steep (i.e. when FOMC members predict a rapid series of rate hikes once the first step has been taken), should we be reassured that this path reflects the Fed’s confidence in the economic recovery, or should we be worried that the Fed is agonising over inflation?;
7. analogous questions can be asked if the interest rate profile is very flat: does the Fed believe that the economy will remain weak and will not respond to the accommodating policy, or is the Fed worried about deflation?

In short, more than enough questions to fill up many analysts’ report, but as an investor you will not be much wiser. Bernanke was asked the key question at this week’s press conference: how confident can one be about forecasts for several years down the line? His response spoke volumes: “Our ability to forecast three and four years out is obviously very limited”. You wonder why anyone even bothers to publish individual forecasts over such a time frame.

I have the feeling that Bernanke was worried that the market might be unsettled by the wide spread of the forecasts (from three FOMC members who are thinking about a rate hike this year to two others who would not raise rates before 2016 (!)). Hence his message that the fed funds rate would remain unchanged until late 2014. If we link this to the longer-term inflation target of 2%, the message, although implicit, is crystal-clear: for those who have debts, inflation will gradually reduce them; and for those who have money to invest, they can choose between paying an “inflation tax” (because interest rates are below inflation) or taking more risk.

No wonder that the emerging country currencies surged on the day after the FOMC meeting.

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

27 January 2012

Risk aversion fatigue

Text published in Le Jeudi (Luxembourg) on 26 January 2012 and in Beleggers Belangen on 27 January 2012.

Client meetings in the past few days in Paris, Helsinki and Vienna had already made me suspect a certain degree of ‘risk aversion fatigue’ among investors, and recent market movements confirm this impression. Various factors explain this phenomenon. For one thing, the current attitude towards the Eurozone is one of ‘no news is good news’. In fact, potentially alarming news is shrugged off. Rating downgrades for numerous countries? No problem. Germany is reportedly not keen to increase the EFSF funding? No problem. And the list goes on. One explanation is undoubtedly the growing awareness that the European Central Bank made a very intelligent decision in pumping almost EUR 500 billion of liquidity into the banking system for a three-year period: banks can use the facility if they are unable to refinance their debt paper at maturity or to buy government paper. And what do we see now? Investors are perfectly prepared after all to invest in bank paper and the auctions of government paper in France, Italy and Spain went quite smoothly. In this light, the prospect of a new ECB three-year funding operation in February sounds as music to the ears.

Another contributing factor is the feeling that the US economy is not in as dire straits as thought. Unemployment is falling, more jobs are being created, small businesses are becoming more upbeat, confidence in the construction sector is improving. If it goes on like this, the current consensus forecast of 2.1% growth for this year will need to be revised upwards. The pessimism of last summer when many feared a new recession is already a distant memory. Interestingly, since last summer the US indicators have systematically surpassed the expectations: despite the overwhelming amount of data, predicting the economy remains a hazardous business.

The emerging picture looks very different from what was deemed possible between Christmas and New Year, when the mood was still doom and gloom. Now it would seem that bad news such as certain corporate results or the relentless rise in oil prices due to the weaker euro has no significance. So the problems have by no means disappeared, even though the newspaper coverage has become less intense. Undoubtedly, the traditional seasonal effect is also playing a role. The equity markets tend to do better in January than in most other months, as many investors think in calendar year terms: they avoid risk towards the close of the year if the results are good at the end of November and start building up risk positions at the beginning of the year when they can start all over again with a clean slate. There is, incidentally, an interesting asymmetry in this respect. When stock markets rise, the expected future return falls, because good news has already been priced in. So what you don’t want at the start of the year is to fall behind the pack, because that means you need to pedal twice as fast to catch up (‘twice as fast’ refers to the fact that the expected future return has meanwhile decreased). If the stock markets fall at the start of the year, you can reduce your position via a price limit and find consolation in the consideration that the expected return has increased (because markets typically fluctuate more strongly than the fundamentals). So for now, let us all enjoy the January effect and prepare ourselves for the European summit at the end of this month, which will no doubt provide a timely reminder of the challenges still awaiting us.

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

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

A tipping point?

The disappointing auction of German government bonds this week is open to diverse interpretations.

1. The ‘animal spirits’ theory, which basically entails that investors – for all sorts of inexplicable psychological reasons – had no appetite for buying. That is obviously not much use for an economist.
2. The ‘wake up’ theory. Large investors from outside the eurozone are fed up with the continuing failure to resolve the crisis and want to send a signal by no longer buying German bonds.
3. The panic theory. Investors, both inside and outside the eurozone, fear that the contagion will continue unabated, and that the eurozone recession will be deeper than the mild recession ECB president Mario Draghi recently referred to a. In this case, Germany would get its share of the economic blows, which would push its public deficit higher.
4. The inflation hawk theory. This assumes a ‘deus ex machina’: Germany gives up its resistance to eurobonds or the ECB agrees after all to the unlimited purchasing of bonds. The first scenario could trigger a strong turnaround in economic confidence and suggest that the ECB is fairly quick to decide that its policy is too relaxed. The second scenario could raise fears that unlimited purchasing would ultimately cause inflation. In both cases inflation-averse investors would refuse to buy German bonds at the current yields. I hasten to add, however, that this ‘inflation hawk theory’ has no basis, given recent statements of both Angela Merkel (‘no’ to eurobonds) and Mario Draghi (‘no’ to the ECB as ‘buyer of last resort’).
5. The tipping point theory. Markets have a fine nose for anticipating dramatic events. When the British central bank decided on Wednesday, 16 September 1992, to prop up the pound sterling in the European Exchange Rate Mechanism (ERM) by further raising the base rate by several hundreds of basis points on an annual basis, stock markets rose because investors realised that this desperate measure was doomed to fail. They were right: the pound withdrew from the ERM later that day. Perhaps the reluctance of investors to buy German bonds signals an expectation that a major event is about to happen, that the ‘definitive solution’ is at hand. Judging by recent comments, this seems, at the very least, optimistic; but you could also argue that necessity is not only the mother of invention, but also of compromise and, hence, of a solution.
6. The ‘enough is enough’ theory. This entails that investors are of the opinion that buying long-term German bonds at the current levels is no longer a good idea as the  real coupon rate is negative (inflation is higher than the nominal interest rate).

This last explanation deserves a closer look. After all, until recently, investors were queuing up to buy German paper even though the real interest rate was already negative. Why this change? I see three explanations.

1. Investors no longer believe in a Japan scenario for the eurozone or Germany: there is no danger of deflation and, hence, no prospect of a continuing fall in interest rates.
2. Investors feel they have already invested enough in the ‘safe haven’ offered by German bonds.
3. Investors do not rule out positive developments in the Eurozone crisis in the fairly short term. As an investor, you can respond to this expectation in various ways: aggressively, by buying instruments that have suffered heavily from the crisis (Italian bonds; Eurozone shares); or more cautiously, by buying fewer German bonds and putting the money in short-term deposits. The duration of ten-year German bonds is about 9 years. And as soon as a solution looks imminent, interest rates could easily shoot up by 100 basis points, thus leading to a price loss of 9 per cent. Against this backdrop, the wait-and-see attitude among investors is understandable.

The six different theories are not equally realistic, to put it mildly. If I were forced to choose the least unrealistic one, I would go for the sixth (‘enough is enough’). But even so, it is premature to say that the ‘silver bullet’ solution is near. However, this week’s events suggest that investors believe we are getting closer to a tipping point. Let’s hope that even this modest expectation is not too optimistic.

William De Vijlder
25 November 2011

R-words

Last week was dominated by two R-words: “referendum” and “recession”. The announcement that a referendum would be held in Greece on a yet to be decided question came as a bolt from the blue. Several weeks ago the Bloomberg website had posted a similar report from Greece, but this was denied by Athens the following day. This time it was serious. At least for a few days. The strength of the market response was linked to the introduction of a new kind of uncertainty: would the referendum be about membership of the eurozone, a question which was thought to be taboo until recently? One can imagine the endless media debates between supporters and opponents. It would have been reminiscent of the debates preceding the referendums on the Maastricht Treaty in the 1990s. But these debates were small beer compared to the issue at hand. A second kind of uncertainty was of course what would happen if the Greeks voted “no” on whether to stay in the eurozone. And then there was a third kind of uncertainty, namely whether the Greek precedent would spark calls for referendums in other countries.

So relief all round when the referendum idea was scrapped on Thursday. The key word in this whole saga is “uncertainty”. In this context I recently read an interesting IMF paper entitled “The uncertainty channel of contagion”. The authors show that uncertainty can lead to contagion, regardless of the traditional channels of contagion. These traditional channels include commercial relations (the trade partners of an ailing country become “infected”), or comparable characteristics (countries which are also ailing come under speculative pressure). “Uncertainty” is a completely new channel: surprises on how the situation develops in a particular country raise doubts about the correctness of the analysis for other countries, and these doubts are sufficient to cause contagion in those countries. Or to put it differently: investors do not want to get their fingers burned again and prefer to be safe than sorry, with the upshot lower share and bond prices. The underlying cause: increased uncertainty.

The second R-word is “recession”. There is no uncertainty on this count, at least not according to the ECB president, Mario Draghi, who in a press conference last Thursday spoke of a “mild” recession in the eurozone. Investors should welcome such clarity, if only because it leaves little doubt about the direction of the policy rate: further downwards.

William De Vijlder

8 November 2011