In  search  of  lost  yields

SPRING  2016

Central  banks’  ultra-­‐accommodative  policies  are  struggling  to  boost  economic  growth,  but   they  do  not   fail   to  make  life  very  dif<icult  for  investors.  To  witness,  risk-­‐free  investments  have  lost  their  yield  virtually  everywhere  in   the  world,  and  have   in  some  countries  even  turned   into  a  penalty   for   investors   !  Global  growth   is  either   in  decline  or  weak.  In<lation  is  rising  slightly  in  the  United  States  but  globally,  we  are  far  from  overheating.  Low  interest  rates  are  thus  here  to  prevail  and  the  hunt  for  yield  will  keep  bringing  investors  to  equity  markets,  an  operation  ...  not  devoid  of  risk.

The  pendulum  points  to  fear

As  is  known,  markets  oscillate  between  excesses  in  both   fear   and   greed.   Greece   is   currently   out   of  investors’   anxiety   radar,   but   this   has   not   ring-­‐fenced   them   to   start   the   year   in   "panic"  mode,   as  they  got  worried,   in   turn,  by  a  hard   landing  of   the  Chinese   economy,   a   recession   in   the  US,   a   growth  standstill  in  the  euro  area,  all  topped  off  by  the  fear  of  a  "Brexit".  Following  a  pretty  hectic  Eirst  quarter,  what’s   in   for   investors?   Markets   are   always   right  for  sure,  but  sometimes  the  perception  of  investors  does  go  beyond  reality.  

Let's  start  with  the  United  States.  Economic  growth  shows   a   modest   2%.   Several   factors   account   for  this.   On   the   one   hand,   the   sharp   fall   in   oil   prices  gave   a   brake   on   investment   in   equipment,   a   key  driver   of   growth.   On   the   other   hand,   household  consumption   has   not   increased   as   much   as  expected  following  this  counter-­‐oil  shock.  Last  but  not   least,   the   stronger   dollar   has   hit   net   exports.  Bottom   line,   Eirst  quarter   growth  will   probably  be  disappointing.

Should   we   however   fear   a   recession   of   the   US  economy?  The  danger  seems  small,  and  for  several  reasons.   First,   with   regard   to   oil   prices,   history  suggests  that  it   is  annual  increases  of  over  20%  in  real   terms   which   are   typically   followed   by  recession,   as   shown  by   the  graph  below.  Certainly  not  decreases  of  50%!  That  said,  the  sweet  spot  for  black  gold   is  probably  a   little  over  $  50  a  barrel,  a  level  above  which  the  production  in  North  America  generates  positive  cash  Elows.

Secondly,   consumers   remain   in   the  driving   seat  of  US   growth,   and   ...   our   favourite   indicator   of   the  annual   variation   of   their   conEidence   remains   well  above   its   "recessionary"   threshold,   helped   as   it  were  by  encouraging  Eigures  on  the  job  market.

US   economic   growth   being   on   a   soft   patch   has   a  pleasing   outcome   for   investors:   the   Fed's   policy  will   certainly   be   less   restrictive   than   the   3   rate  hikes   announced   last   December.   Among   the  indicators   that   attest   it,   we   can   use   the   so-­‐called  "Taylor  rule"  which  provides  an  estimate  of  where  the  key  rate  of   the  Central  Bank  should  be,  based,  Eirstly,  on  differences  between  the  rate  of  measured  

1.  The  fall  of  crude  per  barrel  should  boost  growth  in  the  USA  economy

inElation  and  its  target  of  2%,  and,  secondly,  the  gap  between  economic  growth  and  its  full  employment  threshold.   The   graph   shows   that   this   theoretical  rate   should   currently   be   negative,   a   sign   that   the  monetary  policy  of  the  Central  Bank  has  no  need  to  be   restrictive   in   light   of   the   low   probability   of   an  overheating  growth.

What   about   other   threats   on   the   growth   of   the  world  economy?  Clearly,  it  is  China  that  dominates  fears.   The   origin   of   the   current   slowdown   in   the  Middle   Kingdom   is   a   major   structural   transition  from  an  economy  traditionally  worn  by  investment  and  exports  to  one  supported  mainly  by  household  consumption.  The  landing  of  the  Chinese  economy  

should   be   smooth,   helped   it   need   be   by  expansionary  monetary   and   Eiscal   policies.   Visible  on  the  previous  graph,  the  deleveraging  process   is  also   a   piece   of   good   news,   although   total   private  credit  remains  high  at  170%  of  GDP.

Perhaps   more   than   the   downturn   itself,   it   is   the  lack   of   reliable   economic   data   that   worries  investors.   Hence,   their   focus   on   any   Eirm   –   albeit  indirect   -­‐   evidence   that   the   economy   is   in  slowdown   mode:   the   currency   devaluations  operated   abruptly   by   the   Central   Bank.   They  caused  quite  a  bit  of  market  turmoil  during  the  Eirst  quarter.   I   bet   that   if   the   central   bank   holds   the  lesson   that   devaluations   do   produce   anxiety,   it  should  act  with  more   tact   to  prevent   capital   Elight  and  new  market  backlashes.

In   the   euro   area,   growth   remained   anchored  around   2%,   and   the   outlook   remains   uncertain.  The  good  news  came  in  March   from  the  European  Central  Bank,  when  it  announced  a  new  arsenal  of  unconventional   monetary   measures   to   boost  growth.   The   key   to   their   success   lies   in   a   more  generous  policy  of   commercial  banks   in  providing  new   credits   to   individuals   and   businesses.   In   this  sense,   the   low   bond   yields   should   reduce   the  incentive   for   banks   to   use   the   quasi-­‐free   liquidity  provided   by   the   Central   Bank   to   buy   sovereign  bonds.   The   "monetary   reElation"   program   of   the  European   Central   Bank   will   eventually   prove  successful,  as  the  ECB  still  has  a  plenty  of  scope  for  the   expansion   of   its   balance   sheet.   This   point   is  made  clear  in  the  chart  below  which  compares  the  evolution   of   the   respective   Central   Banks   balance  sheets   in   the   US,   Japan,   Switzerland   and…   the  Eurozone.

2.  The  "Taylor  rule"  excludes  any  monetary  tightening  from  the  Fed

3.  China  ;  Consumer's  deleveraging  continues  

4.  The  ECB  still  has  room  to  manoeuver

The   "Brexit"   will   continue   to   rank   high   on  investors’   “worry   agenda”:   the   probability   that  such  nightmare  scenario  comes  true  is  low  but  we  cannot  rule  out  that  the  populist  arguments  of  the  UKIP   party   will   ultimately   prevail   over   reason.  Sterling  would  be   the   Eirst   victim  of   the  Brexit,   as  the   currency   is   still   overvalued   by   a   good   15%   in  relative  to  its  purchasing  power  parity  level.  On  the  macroeconomic   front,   we   can   estimate   that   the  damage   from   Brexit   be   up   to   10   times   higher   for  the  United  Kingdom  than  for  the  European  Union.

In   short,   global   economic   growth   will   therefore  remain  low  in  developed  countries,  and  will  slow  in  emerging   countries,   especially   China.   Faced   with  this   subdued   growth,   what   are   the   prospects   for  the   policies   of   central   banks   and   for   the   Einancial  markets?

Central  banks  have  wiped  out  risk  free  rates

All   over   the   world,   central   banks   have   blown   up  their  balance  sheets,   Eirst  by   lowering  key   interest  rates  to  a  minimum  and  then  by  massively  injecting  liquidity  through  bond  purchases.  As  a  result,  risk-­‐free   yields   have   almost   disappeared,   both   for  short-­‐term   liquidity   and   for   many   government  bonds.   In   Germany,   the   Netherlands   and  Switzerland,   bond   yields   have   turned   negative  shortly  after  the  Swiss  National  Bank  has  opted  for  the  negative  rate  policy,  in  December  2014.

It  is  not  in  the  habits  of  central  banks  to  fully  open  the   liquidity   tap.   They   have   being   doing   so   since  the  2008  crisis   in  an  attempt   to  stimulate  growth,  and   possibly   even   break   the   neck   of   the   deElation  threat.   The   key   to   success   remains   a   more  generous  policy  of  credit  conducted  by  commercial  banks.

At   time  to   take  stock,   it   is  clear   that  central  banks  have   only   very   partially   achieved   their   growth  target.   Credit   fails   to   restart   lastingly   in   the   euro  area   and   in   Switzerland,   the   franc   remains   the  most  expensive  currency   in  the  world.  The  former  partly  accounts  for  the  latter:  the  lack  of  growth  in  the   euro   zone   is   such   that   investors   fear   that   the  debt   overhang   in   the   peripheral   countries   of   the  euro   zone   like   Greece   might   return   under   the  spotlights.    Thus  the  franc  retains  its  role  as  a  safe  haven  currency.

We  are  probably   expecting   too  much   from  central  banks  today.  As  the  saying  goes:  they  can  bring  the  horse   to  water,   but  when   it   comes   to   forcing   it   to  drink   ...   That   is:   central   bankers   can   open   the  liquidity   tap.   But   if   commercial   banks   are   not  

thirsty,   credit  will   not   restart,   growth  will   remain  sluggish   ...   and   bonds   will   continue   to   offer  unattractive  returns.

Risky  assets  attractive  by  default?

With  bond  yields  close  to  zero,  when  not  negative,  both  private  and  institutional  investors  are  pushed  to  fetch  income  of  the  real  estate  side,  or  high  yield  bonds,   alternative   investments,   absolute   return  strategies  and,  of  course,  Equity  markets.

Equity   markets   valuations   are   not   signiEicantly  different   from   their   historical   averages.   The  attractiveness   of   risky   assets   is   measured   mainly  with   the   lack   of   yields   offered   by   cash   and   bond  markets.   For   example,   the   MSCI   EMU   -­‐   which  groups   10   major   developed   countries   of   the  European  Union   -­‐   displays   a   dividend  yield  which  is  4  times  higher  than  that  of  European  bonds!

Buying   Equities   because   bonds   do   not   offer  attractive  returns  makes  sense  but  …  is  not  without  risk!   The   attractiveness   of   risky   assets   by   lack   of  alternatives  must  be  played  out  with  caution  in  any  investment   policy,   especially   as   economic   growth  halftone   provides   a   satisfactory   macroeconomic  framework,  but  without  panache.

Michel  GirardinEconomic  Advisor

5.  Eurozone  ;  Dividend  yields  plead  for  Equities

Money-­‐market  and  Fixed-­‐income

Amidst   an   across-­‐the-­‐board   economic   slowdown,  global   economic   activity   sent   out   slightly   more  encouraging   signs   during   the   second   half   of   the  Eirst   quarter.   The   US   dollar’s   weakening   and   the  commodity   price   rally   helped   relieve   pressure   on  emerging   economies,   and   accommodating  measures  by  the  main  central  banks  helped  reElate  Einancial   asset  valuations.  The  Fed  played   for   time  by  reducing  its  cycle  to  two  key  rate  hikes  in  2016,  while   the   ECB   accelerated   the   pace   of   its  quantitative   easing   while   boosting   credit   and  supporting   the   banking   sector.   Sovereign   yields  rose   slightly   in   the   US   (1.7%   on   10-­‐year   paper)  while   turning   back   down   in   the   euro   zone   (to  0.15%  on  10-­‐year  German  paper).  In  our  balanced  allocation  we  continue  to  focus  on  high  yield  bonds  (14%)   and   convertibles   (6%),   on   which   we   have  r e d u c e d   t h e   a v e r a g e   s e n s i t i v i t y.   O u r  underweighting   of   investment   grade   and  overweighting   of   money-­‐market   and   cash   (24%)  continues  to  penalise  returns.                                                  

Equities

Prospects   of   a   steep   and   sustained   correction   in  equity  markets   gave  way   to   renewed   optimism   as  fears  of  a  US  recession  and  a  hard  landing  in  China  faded.   However,   the   upturn   in   US,   emerging   and  commodity  indices  has  come  at  the  expense  of  euro  zone   and   Japanese   markets,   which   remain   quite  depressed.  We  moved  to  a  slight  underweighting  of  equities   in   our   balanced   allocation   (43%   vs.   45%  neutral)   while   reducing   our   weighting   of   Europe  (16%)   and   raising   our   emerging  market   exposure  (5%).   We   also   rebalanced   the   portfolio   towards  value  and  away  from  growth.                            

Currencies

After   a   long  period  of   gains,   the  US  dollar  began  a  phase   of   consolidation   in   the   wake   of   a   rally   in  commodity   and   emerging   markets.   Despite   its  overvaluation  it   is  hard  to  bet  on  a  falling  dollar  as  long   as   monetary   policies   remain   uncoupled  between   the  US   and   the   other  main   countries.  We  unwound  our  tactical  exposure  to  the  US  dollar.              

Outlook

For  the  market  rally  to  have  legs,  new  tangible  signs  are  needed  of  a  stabilisation  in  the  global  economy  and   a   coming   acceleration   in   growth.   Emerging  economies   have   once   again   become   attractively  priced   but   are   not   yet   out   of   the   woods   both   on  cyclical   and   structural   plan.     Among   developed  economies,   Japan   and   Europe   are   having   a   hard  time   getting   back   on   the   path   of   virtuous   growth,  with  the  euro  zone  also  facing  governance  problems  that   could   darken   its   outlook.   In   the   US,   the  situation  appears  to  be  stabilising  in  the  direction  of  moderate  growth  driven  mainly  by  consumption.    In  a   non-­‐inElationary,   low-­‐interest   rate   universe,  investor   risk   appetite   is   natural   and   justiEies   high  valuations.   But   for   how   long?     Caution   is   still   in  order,   in  our  view,  and  we   feel   that  apart   from  the  catching   up   by   certain   markets,   the   current   rally  now  has  little  room  to  go.                                                                                          

Armand  du  Pontavice,  CIO

Investment  Policy