The New Normal is Non-Normal

PWM investment strategyYves Bonzon, CIOJanuary 2012

Secular Trends year 3 -

Strategy 2012 The New Normal is Non-Normal

3Secular Trends Year 3 - Strategy 2012Pictet

Key 2010’s trendsEvery decade is characterized by a different economic and investing environment

60’s 70’s 80’s 90’s 00’s 10’s

Bretton

Woods

US Nifty Fifty stocks

Floating FX

Oil shock

Inflation

Small Caps

Oil stocks

Gold, CHF and JPY

Disinflation

Plaza

Arbitrage

Gvt

bonds

Nikkei

Hang Seng

Fall of Berlin Wall

Globalization

Internet

E-trading

Indexing

Nasdaq

SMI

USD

EMU

Great global imbalance

China’s rise

Structured credit

Hedge funds

EM equities

Commodities

EUR

?


1945 –

2007 leveraging cycle

US debt to GDP2007 was an inflexion point in terms of debt accumulation in Western economies.

We have entered the managed deleveraging era.


In a balance sheet recession

•

Austerity is doomed to fail

•

Three solutions to insolvency:

-

Transfers, money printing, restructuring

•

Capital flees from weak balance sheets

to strong ones.

•

Strong countries resist

the appreciation of their currencies.

•

A coordinated solution is unlikely.

Key Points


US employment

US total payroll employment excluding census hiring: level in millions of workers

No net creation in 12 years

Source: AA&MR, Datastream

90

95

100

105

110

115

120

125

130

135

84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

November 1999

Mio


Household formation was very weak over the past 5 years or so

100

102

104

106

108

110

112

114

116

00 02 04 06 08 10 12

Millions

2.7

Number of households

Trend based onadult population

It should re-accelerate over the coming years. Moreover, “shadow demand”

has built up

Number of households: effective and trend estimates

Source: AA&MR, DatastreamSource: AA&MR, Datastream

On trend, the natural rate of US household formation is about 1 million annually.

The depressed level of housing activity and the missing 2 or 3 million jobs related have depressed household formation to the same extent.

Fundamentally US demographics are not deflation prone, unlike Japan.


6.2

6.4

6.6

6.8

7.0

7.2

7.4

7.6

Jan-68 Jan-71 Jan-74 Jan-77 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10

Real Average Existing House Price (log scale)

Real Case-Shiller Composite Index (log scale)

Real OFHEO/FHFA House Price Index (log

Trend = 1.5% per annum

1 SD = 6.7%

37% Decline

15%Decline

30% Decline

US house prices

US house price indexesOne of the cheapest investable asset class but the overhang is not cleared yet.

US families will switch from an owner’s mentality to a rental mentality. This is a 2 generations’

turn.

Source: CS


China’s economy at horizon 2015

China’s nominal GDP share in world GDP

USD* 2'224 bn

USD* 4'814 bn

USD* 1'196 bn

USD* 10'076 bn

USD* 9'073 bn

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Bull Case (9% growth)

Bear Case (6% growth)

*2004 constant USD

China would reach between 12% and 16% of world GDP by 2015 at 6%

respectively 9% real growth



China: middle income trap?

China may be old before it gets richFew people realize how fast China is aging.

Labour force is actually starting to decline from next year onwards.

Furthermore, they might be caught in a middle income trap where they become too expensive relative to place such as Vietnam and not skilled enough relative to advanced countries.


Gold: target raised to $ 3’000.-

(from $2’000.-)

Dow/Gold ratioWe are slowly getting towards of target ratio of 5

ounces of gold for 1

unit of the DJ Industrial Index.

Monetary disorder of the deflation or inflation kind would justify a lower ratio.

In nominal terms, if deflation ultimately prevails, $ 2’000.-

is the maximum potential.

If inflation gets out of control gold might be confiscated.

Insert here

your

graphs and tables


Corporate bonds

6.0

6.6

7.2

7.8

8.4

9.0

9.6

10.2

10.8

11.4

12.0

12.6

13.2

3.4

3.6

3.8

4.0

4.2

4.4

4.6

4.8

5.0

5.2

5.4

5.6

5.8

6.0

% %

Investment grade

High yield

H2 09

Merrill Lynch Master index

H2 10 H1 11H1 10 H2 11 H1 12500

550

600

650

700

750

800

850

900

950

1'000

1'050

180

200

220

240

260

280

300

320

340

360

380Bp

Bp

Investment grade

High yield

H2 09

Merrill Lynch Master index

H2 10H1 10 H1 11 H2 11 H1 12

US corporate bond yield US corporate bond spreads

Source: AA&MR, DatastreamSource: AA&MR, Datastream

Quality corporate bonds are historically the best asset class in

a de-leveraging cycle


Investment rules in a deflationary environment

•

Favour strong balance sheet linked investments.

•

Beware the pitfalls of low valuations.

•

Focus on:

–

Cash and government bonds of countries that can print their money

–

High grade corporate bonds

–

Defensive equities

–

Gold

•

Minimize leverage.

Key Points


SAA: allocating capital by strategies and risk factors

PWM strategic asset allocation 2012We shall progressively move to an asset allocation driven by strategies and risk factors.

The TAA bucket will be implemented through beta instruments.

For the other buckets, we shall use a variety of suitable portfolios and instruments.

E 2 3 4Fixed income Conservative Balanced Growth Strategies

Credit risk premia

EM debt FXGold

TAA bucket

Alternatives trading

Equity defensive

Equity growthAlternatives low volREITs


Pictet’s

secular outlook: summary

•

Bimodal distribution

of returns on financial assets.

•

Diversify by strategies

rather than by asset classes and

dedicate capital to a tactical bucket.

•

GDP growth is the dominant variable for equities.

•

Policy decisions

trigger violent rallies.

•

Emerging equities

are only a super cyclical

asset class.

•

Financial repression

has begun.

Key Points


Key 2010’s trendsEvery decade is characterized by a different economic and investing environment

60’s 70’s 80’s 90’s 00’s 10’s

Bretton

Woods

US Nifty Fifty stocks

Floating FX

Oil shock

Inflation

Small Caps

Oil stocks

Gold, CHF and JPY

Disinflation

Plaza

Arbitrage

Gvt

bonds

Nikkei

Hang Seng

Fall of Berlin Wall

Globalization

Internet

E-trading

Indexing

Nasdaq

SMI

USD

EMU

Great global imbalance

China’s rise

Structured credit

Hedge funds

EM equities

Commodities

EUR

Managed Western de-leveraging

EM discrimination

Tech led cycle

Asset price targeting

End of $ paper standard or EUR ?

TAA and risk factor based SAA

Gold

EM local debt

Oil services

Developed quality blue chips


Double decoupling

Source: AA&MR

Economic policies are not coordinated, not cooperative, not homogenous. They generate disequilibrium.

Central scenarioDouble global decoupling in DMs

versus EMs

Buoyant domestic demand

Strong revenues growth

Change in the economic model from exports-

based to domestic based-

demand

Diffusion of inflation

Rise in labour

costs

Emerging Markets

Developed Markets

Lack of domestic demand

Sluggish revenues growth

Credit overhang

Keynesianism

Debt deflation

QENew supply side economics

No growth in EU and growth recession in the US. Stabilizing growth in EMs.No debt crisis in EMs.

Alternative scenarioIntensification of the euro crisis. Double-dip in DMs. QE in DMs

source of inflation in EMs.

Tail event scenarioFiscal union on BCE’s QE. Fiscal policy boost in DMs. Accelerating economic growth in DMs.


From 2008, DM economies have entered an over-indebtedness regime

Source: AA&MR

Solvency Territory

Great divergence

Debt-financed economic growth

Debt is out of control without drasticmeasures to cut debt or to boosteconomic growth

2008

Greece

IrelandPortugal

France

Spain

Germany*

Italy

Switzerland

Norway

USA*

0.7 %1.5 %

1.7 %

1.5 %

0.7 %

0.4 % 2.2 %

3.3 %

2.7 %

2.7 %

1.6 %

162.8 %

101.6 %

120.5 %

85.4 %

69.6 %

108.1 %

22.8 %

101 %

81.7 %

40.9 %

38 %

Consensus 5y avg

real growth rate 2012 -

2016

Debt / GDP ratio 2011

Trajectory of nominal economic growth

Trajectory of public debt

Australia

United Kingdom*2.1 %84 %

New Zealand2.9 %35.3 %

Sweden2.2 %

36.3 %

Insolvency Territory

Public debt to GDP ratios start rising in DM’s

1980

Japan1.5 %220 %

* Prevailing market status of sovereign bonds issued by these countries still allow us to consider them as solvable

44Secular Trends Year 3 - Strategy 2012PictetPictet

In an over-indebtedness regime, DM governments have 3 incompatible targets

Source: AA&MR,

Political target:Re-election

Keynesian pro-growthfiscal policy

Satisfying financialmarkets’

requirements

Public deficit

Cuts in Government spending

Increase inpublic debt toGDP ratio

Innovation shock

Reallocation of theadded value fromcapital to labor

Supply sideeconomics

European fiscal union

Default and restructuring

Monetization of debt

Set of possible European crisis responses

Governments’

targets OutcomesSet of economic policy responses

?

?

?

45Secular Trends Year 3 - Strategy 2012PictetPictet

Global systemic risk

Deep recession

European systemic risk

Mild recession

Mild growth

Growth at potential

The five possible outcomes of the euro crisis

Source: AA&MR

European debt crisis

Fiscal union

The euro remains the euro (risk of Greece exiting the Eurozone)

Blue euroRed

euro

Euro = D-Mark zone+ 11 national currencies

Implosion:17 national currencies

Ultimate form:European governmentEuropean fiscal policyEuro-bonds

Monetization of debt by the ECB

Political burst

Sovereignty of States

Sovereignty of States

20%

35%

20%

20%

5%

Euro outcomes Economic scenario

Probabilities

Low volatility

Medium volatility

High volatility


Identifying 3 market regimes with the VIX

VIX index (new VIX starting January 1990)A rule of thumb on market volatility

10 -

15, low volatility regime

15 -

25, significant risk

Above 25, fear of systemic risk

After the Euro Summit of 27 and 28 October, the VIX reverted back to 25 on before sky rocketing again after the Papandreou proposed referendum announcement.


0

10

20

30

40

50

60

70

80

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

150 on19 October 1987

Systemic risk

Cycle with some risk

Standard cycle


40

50

60

70

80

90

100

110

08 09 10 11

Pictet

Pictet’s FX barometer: market factored in a European systemic riskRelative performance: carry trade versus value strategies (01.01.2008 = 100)


Scenarios

Intensity of the macro scenario

Mild growth

Growth at potential


Deep recession


Mild recession

Buy Sell

Carry tradeCAD, AUD, NZD,

NOK, SEK

USD, EUR, JPY

GBP, CHF

ValueUSD, EUR, JPY

GBP, SEK

CHF, CAD, AUD,

NZD, NOK


150

170

190

210

230

250

270

290

310

10.08 10.09 10.10 10.11

STOXX EUROPE 600 E - PRICE INDEX

Pictet

Pictet’s equity barometer: market factored in a European systemic risk

Stoxx

Europe 600


Scenarios

Intensity of the macro scenario

Mild growth

Growth at potential


Mild recession


Deep recession

Low volatility

Medium volatility

High volatility


Bonds: 10-year bond yields fell heavily in Q3 before rebounding

US Treasury 10-Year bond yield and model estimates

Due to a high core inflation rate, our fundamental model is still pointing to a fair value of 3.7%


1

2

3

4

5

6

7

8

9

86 88 90 92 94 96 98 00 02 04 06 08 10 12

%

Model*

10-year bond yield

*Based on short-term rate, core inflation, economic growth and budgetary deficit

Systemic risk premium in a high volatility regime

10-Year

US Treasury

yield

and directional

pressure

Insert here

your

graphs and tables

0.00

1.00

2.00

3.00

4.00

5.00

6.00

06 07 08 09 10 11 12 130.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

100.00

US 10 Year

Note Yield

Directional

Pressure Index 0 -

100 (leads

19 months)

Dece

mbe

r201

1M

ay 2

012


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The New Normal is Non-Normal

Economy & Finance

Transcript of The New Normal is Non-Normal