30/09/2011: Leaving the portfolio comfort zone

In the last 10 years, world growth did not start in the West, nor did equity market performance; these have been more or less flat for a decade. Instead, emerging markets yielded 70% to 100% of world growth, depending on the year. Average portfolios of Western clients, however, have not reflected this fact.

Europe is now in its worst crisis since the inception of the euro. The outcome could yet be very nasty. The US has struggled with poor growth since the 2007–2008 financial crisis; this may go on indefinitely. Japan has never recovered from the burst of its stock and housing bubbles some 25 years ago. There are not many places to hide in the developed economies. They also face high public debt as well as the challenge of over-aging societies.

While emerging markets now generate 50% of world GDP when measured in purchasing power, this amounts to merely 30% when measured with market exchange rates – showing that their currencies are still massively undervalued. Data from Capgemini, however, show that portfolios in developed economies have between 85% and 95% of their assets invested in developed economies, with a significant portion in home markets. US investors invest in the US, Germans in Germany, the Swiss in Switzerland. This “home bias” can be seen as one cause for poor portfolio performance over the last 10 years.

People tend to buy what they know; they consider what is farther away more risky. This attitude has some merits. Currency risk, costlier information gathering, tax and legal concerns can arise. But even accounting for those factors, there remains a systematic underweight of emerging markets in portfolios of developed market investors. Two misconceptions might explain this: hindsight bias and a traditional apprehension toward very volatile assets.

Past performance is no guarantee for future performance, so one cannot argue that emerging markets have performed absolutely, well ahead of developed markets over the last decade, and so project future returns. Nevertheless, the future appears favorable for emerging markets. Many are converging towards the developed economies, so their growth rates will go on outperforming in the long run. Encompassing setbacks and conservative growth assumptions, one still arrives at forecasts that emerging markets will account for 65% of the world economy by 2025 and 75% by 2050.

As for volatility, politics, the rule of law and corruption still mark many emerging markets. But in the US and in Europe of late we have also wanted for political leadership, visibility and accountability. In fact, considering the financial crisis which hit the US in 2007–2008, and the sovereign debt crisis which is currently unfolding in Europe, emerging market investors are far less dazzled and confused than developed economy investors, since those crises appear familiar to them.

Don’t get me wrong, I am not pleading for a large-scale shift of assets from developed to emerging markets, but leaving the usual comfort zone and seeing emerging markets with new lenses is in my view likely to be rewarding from a risk-return perspective.

23/09/2011: Spicy goulash… soon available in Austria?

The land of the Magyar is far from the European periphery, but potential for high temperament can be both engaging and infectious.

The acronym formerly used for Portugal, Ireland, Greece and Spain has been updated to include market focus on Italy and to improve political correctness, so we reorder the letters and call this new coterie GIIPS; the muddle that markets see there is the same. Greece will eventually default, goes the narrative, and Portugal and Ireland are next, but in fact these latter two countries are under the umbrella of the European Financial Stability Facility (EFSF) at least until end of 2013.

Spain and Italy are more critical; the latter’s sovereign debt was just downgraded by Standard and Poor’s from A+ to single A with a negative outlook. The European Central Bank (ECB) is buying these nations’ government bonds to lower the interest rates. Beyond the GIIPS, market participants consider Belgium, with a government debt-to-GDP ratio above 100%, and France, also with negative debt dynamics, as potentially critical.

Germany, the Netherlands, Finland and Austria are presently the only countries not disturbed by the euro crisis. But actually, the next bout of indigestion could come from a source which has previously simmered very calmly: Hungary.

There, between 2004 and 2008, some HUF 4 trillion worth of mortgages and consumer loans were ladled out in Swiss francs because households wanted to profit from the comparatively much lower CHF interest rates. Today this debt composes 60% of all Hungarian mortgages and 16% of Hungarian GDP. Similar situations exist in Poland and Croatia but are not as extreme.

The problem with these Hungarian mortgages is that back in 2008 the CHFHUF exchange rate was at 160, while today it is at 240. Thus the franc and the value of CHF-denominated mortgages and consumer loans have increased by 50%. Indebted Hungarian households are under stress; someone put way too much paprika in the goulash.

To ease households’ debt burden temporarily, Hungary recently introduced an exchange rate fixing scheme. Interest payments are thereby made at a fixed exchange rate of 180, i.e., 25% lower than the current market rate. To fill the gap between this fixed exchange rate and the spot rate, banks issue bridging loans, to be repaid after 2014. Now Austria enters the fray, and to a lesser extent Germany.

Eurozone banks expanded heavily into Eastern Europe in the last decade. The Bank for International Settlements reports that today some 80% of Hungary’s banking sector is foreign-owned, with Austria accounting for 27% and Germany 21%. A large part of Hungary’s CHF-denominated debt was served by Austrian banks; German banks accounted for a lesser amount. Assuming that a large portion of the currency exposure was not hedged – which one must, since otherwise the interest rates on the Swiss franc loans wouldn’t have been so tasty – foreign and particularly Austrian banks are now at risk of a surge in non-performing loans. To spice the dish even more, the Hungarian government just announced the option for borrowers, if they can come up with the cash, to repay their mortgage at the favorable rate of 180 and let banks assume the loss in the gap.

Austria can well support its banks should the current situation cause discomfort. Nevertheless, if the story gets too hot, market participants may take such contagion as further evidence of the deepening debt crisis, inducing a reassessment of Eurozone safety as a whole.

16/09/2011: Eurozone politicians just can’t win

The Eurozone’s debt crisis certainly looks quite intractable, but in fact several options could stabilize or even mitigate the situation. The problem? They are all hard sells for elected politicians.

Let’s call them the three Es: Eurobonds, the EFSF and the ECB. Each could play a role in tackling the ongoing Eurozone crisis, but each would also entail costs that electorates are unlikely to accept. As Euro Group President and Luxembourg Prime Minister Jean-Claude Juncker once said of other unpopular economic reforms: “We all know what to do, we just don’t know how to get reelected after we’ve done it.”

Eurobonds – so goes the theory – would replace country-specific bonds with a common bond that pools Eurozone governments’ sovereign debt. The conditions governing issuance would presumably ensure that no single country puts itself into excessive debt. This solution seems to have a lot going for it at first glance, as the Eurozone ratio of sovereign debt to gross domestic product is better than that of the UK, the US or Japan. But this doesn’t guarantee that rating agencies will play ball: Standard & Poor’s has already warned that it won’t rate Eurobonds any higher than their lowest-rated participants.

During the subprime crisis, we learned the hard way that you can’t mix AAA- and CCC-rated debt and expect to get untainted AAA debt as a result. I don’t think you can call it CCC, either – but nevertheless, presenting Germany, France and the Netherlands with the prospect of losing their AAA ratings makes this solution rather difficult from a purely political perspective.

The European Financial Stability Facility (EFSF) could also mitigate the current crisis. But many analysts and market participants think it would need far greater means at its disposal, especially if Italy keeps looking vulnerable. We often hear two trillion euro as a target figure. This would certainly exceed Germany’s financing capability, and with so much depending on German taxpayers, politicians there won’t be able to win elections even with a lower number.

Finally, the European Central Bank (ECB) could play a part in taming the crisis by buying more government bonds from troubled countries. It used this tactic at the beginning of the crisis, and revived it again in the last few weeks as Spain and Italy came under increasing attack. Nevertheless, detractors claim that a policy like this raises the long-term risk of inflation. In fact, ECB chief economist Jürgen Stark recently resigned over this very issue, showing that the bond-buying option won’t win many friends in inflation-phobic Germany.

Creating the euro was a political project, not an economic one, and rescuing it will therefore require a political decision. Economics can only help to identify the costs associated with the possible solutions, and these costs will of course make it difficult for decision makers to get reelected. Forced to choose among various costly and unpopular options, European politicians just can’t win.

09/09/2011: SNB decides enough is enough

Perhaps, it was one of the boldest moves by any central bank or economic decision-maker since the beginning of the financial crisis in 2007/08. Certainly, it was one the most unexpected, and it must have caught many investors on the wrong foot.

At 10 a.m. local time on 6 September, the Swiss National Bank pounded a fist on the table and said, “Enough!” The communiqué was unambiguous and left no room for interpretation or second-guessing: “With immediate effect, (the SNB) will no longer tolerate a EURCHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.”

The markets received the message loud and clear. Within seconds, the Swiss franc lost 10 big centimes against the euro and seven against the US dollar. To all those who had argued that the central bank of a tiny country like Switzerland cannot withstand the power of the markets, the SNB’s bold move was a strong counterattack. Indeed, a central bank can always fight the appreciation of its own currency. It has the means: “unlimited” quantities of money created through the printing press. All it needs is the will to do it and the ability to bear the long-term consequences.

The first critique that came after the move was an obvious one: What would happen with inflation? At the moment, this debate is futile. With the largest Swiss retailers Migros and Coop slashing their prices, and with export firms extending workers’ hours to the limit without increasing their salaries – thus effectively decreasing hourly wages – Switzerland is on a deflationary path. No doubt about it, inflation pressures will come in the long run; but even at a rate of 1.20 against the euro, the Swiss franc is currently having a deflationary effect. It means the long run can be rather long.

Markets will test the will of the SNB over the next couple of weeks. However, in my view, given the very strong language of the communiqué – and unless the SNB wants to completely lose its credibility – it will defend the 1.20 limit tooth and nail.

What does this mean for investors? As long as the SNB is defending the 1.20 limit, the Swiss franc in principle no longer bears any appreciation risk against the euro. This fact could be the basis for building up carry trades by using the franc as a funding currency to invest in bonds in euros, with higher yields than the ones in Switzerland.

Should this strategy catch on and become fashionable, the SNB will have won the battle, because carry trades usually undermine the value of a currency. As a funding currency, the Swiss franc could quickly retreat against the euro to 1.25, 1.30 and even beyond without the need for further SNB intervention.

Of course, it is still too early to say that the SNB has won the war against the brutal appreciation of the Swiss franc. But it has at least won a battle by spreading doubt among the markets that the franc is as good as gold and a safe haven. In my view, with a strong will and thanks to the oddity of carry trades, it might be able to extend its advantage sooner rather than later without putting too much money on the table.

05/09/2011: Will Mad Men take over the Fed?

Ever since the HBO series Mad Men conquered the TV screens, the 1960s are back in fashion. Mixing fancy cocktails, wearing hats, listening to the Beatles and the Beach Boys and even chain-smoking are back in vogue. Can the Federal Reserve resist this fad? According to more and more investors and analysts, the answer is no. Meet Operation Twist.

What sounds at first like the name of a martini or a James Bond movie is a monetary policy option explored in February 1961.

After two rounds of quantitative easing, which while stabilizing the US economy didn’t really help to re-boost it, something else must be attempted. Quantitative easing was about increasing the monetary base, providing liquidity to the market and (in QE2) lowering yields on the long end of the interest curve by purchasing government bonds on the secondary market.

In a Washington Post op-ed on 4 November 2010, Federal Reserve Chairman Bernanke explained QE2 as follows: “Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Two months after the end of QE2, the bottom line is rather sobering to say the least. US unemployment has stalled above 9% with the US economy not creating any jobs in August, the housing market continues to be deeply depressed, credit activity is slim and the gains on the stock market after the introduction of QE2 have already been halved. The main problem with plain vanilla quantitative easing remains the fact that the cheap central bank money is not transmitted to the economy through the credit channel.

Money multipliers, which would show this transmission, remain stuck at their low post-financial crisis levels. Financial intermediaries seem to prefer using the cheap money they can get at the Fed to invest in government bonds instead of lending it to the private sector.

Operation Twist would remedy this. At least this is what many analysts seem to think and why it has become the most hotly debated “new” option of the Fed. In a nutshell, the central bank would issue short-dated bills and use the proceeds to buy long-dated government bonds. By doing so, it would lift the short end of the yield curve and lower the long end, thus entering in direct competition with the financial intermediaries on the government bond markets while at the same time pushing their refinancing costs higher.

Flattening the yield curve is commonly considered to be a more restrictive policy. Spreads, the difference between long and short interest rates, are therefore usually a rather good business cycle indicator because the lower they are the lower growth will be. Why then this counterintuitive measure in an environment of low growth? The reasoning behind such a policy is that with lower government bond yields and higher refinancing costs financial intermediaries will have an incentive to increase their lending activity again instead of investing in government bonds, thus boosting the housing market and firms’ investments.

In theory, such a policy makes sense, but we believe there are several caveats. First and foremost, a policy aimed at getting financial intermediaries to lend more is in blatant opposition to the aim to make those financial intermediaries financially more solid in the aftermath of the financial crisis. It is not a done deal that the balance sheets of many banks have been repaired and cleaned enough to allow them to increase their risks yet again. But even if this would be the case and this is the second caveat, it is not a done deal either, that households and firms will be willing to take more credit again.

Japanese economist Richard Koo, who wrote the seminal “Holy Grail of Macroeconomics” explaining the financial and banking crisis of the early 1990s and the subsequent deflationary stagnation of Japan, is making this argument: “The economics profession has never considered a recession that could be caused by the private sector minimizing debt in order to repair balance sheets after a debt-financed bubble in asset prices. As a result, the profession has no clue as to what is the right thing to do. In this rare type of recession, monetary policy is useless because people with negative equity will not borrow, no matter what the interest rate. Nor will there be many lenders when banks have such huge problems with their balance sheets.”

While we don’t know now whether an Operation Twist will be implemented as the next move of the Fed, we can already assess now that its success is less than certain. Nevertheless, an Operation Twist would at least in the short run challenge our call for short duration since it aims to lift short-term interest rates and reduce long-term interest rates. Hence, it will be an important event to follow closely.

02/09/2011: Recession… again! Do we know and can we respond?

The likelihood of a US recession was one of two main fears, the other being the European sovereign debt crisis, which drove equities much lower during August. The dive abated somewhat last week on the news that at least Federal Reserve Bank Chairman Ben Bernanke doesn’t see recession as a prime scenario so far. Nevertheless, the question whether the US and other regions are heading back to a recession will haunt us for the next couple of months.

The common definition for a recession is two quarters in a row of negative gross domestic product (GDP) growth. While this definition is also used in the US, identifying “official” recessions is actually the responsibility of the National Bureau of Economic Research (NBER). To do so, it uses a battery of statistics reflecting not only real GDP but also employment and real income. Since identification is a cumbersome procedure, it usually takes between 12 and 18 months for the NBER to declare the beginning or the end of a recession.

Assuming that the US entered a recession in July or August 2011 would mean that the NBER would declare that condition by fall 2012 at the earliest. Hence, the NBER approach is not very useful for investors, who want to know whether we are in a recession now or are heading into one within the next couple of months. Fortunately there are several techniques to estimate at least the likelihood that we are in a recession. These compile a bunch of current business cycle statistics and deliver a probability that we are in a recession. Such models are now giving probabilities between 0% and 40%, depending on the statistics included or excluded. On average the result is roughly 30%, not enough to make it our central scenario but still enough to be considered rather plausible.

With recession risks rising to uncomfortable levels, elevated corporate earnings expectations could bring equity markets down further. During recessionary periods, earnings expectations are massively reduced, creating negative pressure for share prices. Given present historically high corporate margins, this downside is considerable in a potential recessionary outcome. The good news is that current valuation levels are long-term attractive, meaning the downside is not as severe as usual – but we think investors should rather search for safety while uncertainty remains so high.

Specifically, we recommend investors who see the recession case as central to reduce their cyclical equity exposure further and move it to cash, corporate bonds or defensive and high dividend yielding equities, depending on their risk profile. We would not regard government bonds as the best safe haven alternative at the current stage of low yields and rising government debt levels. Exposure to broad-based commodity indices should also be reduced.

We don’t know for sure, whether we are in or will head into a recession, but we know that the risks are not negligible. Hence it is paramount to at least stress-test your portfolio for such a scenario. Markets will remain volatile until the answer becomes clearer.