November 2012 - Pictet Perspectives

3 downloads 162 Views 581KB Size Report
purchase of mortgage-backed securities (MBS) represents only 1.4% of the Fed's current balance sheet .... The degree of
Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page1

1.4%

Current proportion of the Fed’s balance sheet represented by its QE3 programme to buy mortgage-backed securities Page 2

30bn

Revised estimated size of Greece’s public deficit for 2012 in euros Page 4

2%

Rate of US GDP growth for Q3 2012, slightly quicker than the tempo in Q2 2012 Page 5

170

Q3 results have been reported by 170 European groups: some encouraging figures after several disheartening quarters Page 7

100

Reading on the composite Ifo Business Climate index for Germany for October this year Page 9

+16%

Rise in the gold price in dollars since May 2012 Page 11

2

Two main schools of thought on asset allocation geared towards risk-factor methods Page 12

60/40

Classic asset-allocation split of 60% in government bonds and 40% in equities no longer delivering adequate diversification Page 13

Central banks and the mountains of public debt November 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page2

EDITORIAL OUTLOOK

Watch the Fed’s balance sheet

We consider the metal silver as one of the types of asset most sensitive to quantitative easing (QE). It is already seven weeks since the Federal Reserve announced a fresh round of unconventional monetary stimulus. However, the price of silver had already begun to rise in mid-August as investors began to discount the measures revealed a month later. So by midSeptember, the markets already reflected, at least partially, the prospect of further expansion in the Fed's balance sheet. All the same, the announcement Yves Bonzon provoked a barrage of comment, especially from the Chief Investment Officer Cassandras who have long predicted the end of the so-called Bretton Woods 2 monetary regime under the onslaught of successive attempts at monetary devaluation by the Federal Reserve. After almost two months of the new programme, we can safely say that the behaviour of financial assets is notably different from the previous two rounds of quantitative easing, as the S&P 500 shows: 160

QE1 announcement 25/11/08 QE2 announcement 27/08/10 QE3 announcement 13/09/12

S&P rebased to 100 at each announcement

150 140 130 120 110 100 90

QE1

80

QE2

QE3 Month

70 -3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

Sources: Datastream, Pictet & Cie

Many commentators conclude from this that the ‘half-life’ of the effect of unconventional monetary interventions is melting away, like snow in the spring sun. This conclusion seems hasty. First, the markets had anticipated unlimited QE for nearly a month by the time of announcement, unlike QE1 and QE2, which took investors by surprise. Then, the USD 40 billion absolute rate of monthly purchase of mortgage-backed securities (MBS) represents only 1.4% of the Fed’s current balance sheet of USD 2.8 trillion. Second, the review of weekly data published by the Federal Reserve shows that, since the programme began in mid-September, the balance sheet has hardly changed.

|2|

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page3

330

2007 average = 100

QE1

QE3

QE2

310

?

290 270 250 230 210 190 170 150 130 110 90 07

08

09

10

11

12 Source: Fed

We see two possible explanations for the way in which the Fed’s balance sheet has evolved. The first is that MBS purchases so far would have served merely to offset the repayment of other assets, probably acquired during previous asset-buying programmes. The second is that MBS purchases were carried out through futures with delayed settlement, and the liquidity effect of QE3 will only emerge in the coming weeks. The initial interpretation of QE as unlimited money printing, leading to inevitable and more or less imminent hyperinflation, now seems outdated. With the orderly deleveraging of the private sector and the prospect of a gradual return to the normal transmission of credit across the Atlantic, the Federal Reserve seems to have achieved a delicate and clever communication exercise: to kill once and for all the fears of deflation, while acquiring for itself a broad discretion to target asset prices by adjusting the size of QE in the coming months. The weekly publication of the size of its balance sheet will now become one of the key statistics to watch.

Perspectives is also available to download. Sign up to subscribe and keep up-to-date online with our views on markets, the economy and key underlying trends on the Perspectives website: http://perspectives.pictet.com

perspectives |november 2012

|3|

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page4

MACROECONOMICS

European systemic risk contained against backdrop of anaemic growth The ECB managed to contain systemic liquidity risk arising out of the eurozone crisis. The fate of the world economy looks set to hinge on what happens to the tentative recovery seemingly underway in the US. Europe’s economy, burdened by the weight of austerity measures, is likely to grow by close to 0%. Christophe Donay*, Bernard Lambert and Laurent Godin *With Wilhelm Sissener

The run-up to the year-end looks set to be eventful, with plenty of twists and turns liable to influence economic cycles. The US economy is hurtling towards a fiscal cliff which, in a worst-case scenario, might slice four percentage points off GDP growth next year. European economies are being seriously debilitated by draconian austerity packages. Growth in the Chinese economy is expected to stabilise at around 7.5%. All eyes now riveted on the US At the time of writing, the outcome of the race to the White House was still unknown. Our scenario outlined below is founded on the assumption, borne out by the most recent poll findings, that Barack Obama would be re-elected. Problems associated with the fast-looming fiscal cliff look most unlikely to be settled before Q1 2013. In the past, determination to work in the national interest has tended to lead to a favourable pro-economy policy compromise being cobbled together by feuding Republicans and Democrats when faced with stark economic realities. A deal along similar lines would, probably, see some of the tax breaks at issue being rolled over. Under our core scenario, we are estimating the negative impact of the fiscal cliff would shave roughly one percentage point off the US’s GDP growth, resulting in a rate for 2013 of just over +2%. Europe’s economy is still being seriously handicapped by the markedly diverging trajectories on economic growth and public debt, a phenomenon we have dubbed the ‘Great Divergence’. It is particularly striking in countries on the eurozone’s periphery. Greece has recently been thrust back into the limelight again: the Greek parliament revised its projection for the country’s public debt ratio for early 2013 from 167% of GDP to 189%. This slippage stems from an estimated public-sector deficit for 2012 of EUR30bn, higher than the EUR20bn previously projected. Although the European Central Bank (ECB) did manage to diminish systemic liquidity risk, the systemic solvency risk hanging over other eurozone member states like Spain and Italy has mounted owing to the draconian austerity measures stifling economic growth. We do not expect to see eurozone growth quickening in the next few months. As for China, its economy has been experiencing a structural step-change down in its growth rate as its economic model gradually evolves, transforming from being export-driven to one fuelled more by domestic consumer spending. In future years, we see growth running at around 7.5%, no longer hitting the heights of 14%. In order to keep a lid on any social unrest, the People’s Bank of China will remain reactive, stepping in with measures if growth sinks below +7%.

|4|

US: major uncertainties about how precipitous the fiscal cliff will be GDP growth has quickened a little in the US, picking up from 1.3% in Q2 2012 to 2.0% in Q3. Brisker growth in consumer spending and robust expansion in residential construction have been encouraging, but lacklustre exports and nonresidential investment are casting serious doubts over the sustainability of this recent gentle economic upturn. With the economy potentially heading for harsh budget restrictions, commonly referred to as the ‘fiscal cliff’, as from January 2013, the likelihood of growth speeding up any further in the next few months looks pretty slender. The degree of fiscal restrictiveness will be dictated by negotiations between the political parties. Bargaining between Republicans and Democrats is likely to be very fractious and heated, triggering significant turbulence on financial markets. If Congress does nothing and passes no new measures, budgetary belt-tightening might well prune as much as around 3 whole percentage points off growth in 2013, plunging the US economy back into recession. Our core scenario is predicated on our belief Congress will push through measures to curb the negative knock-on effects from the fiscal cliff to around one percentage point of growth. That would still be quite significant and, as things stand, anything frankly still looks possible. Worse still, the need for the Federal debt ceiling to be raised by early March 2013 at the latest seems most likely to result in political upheavals dragging on throughout most of the first quarter. All in all, growth will probably dip temporarily in Q1 2013, but we are upbeat about prospects beyond. Underlying economic fundamentals are favourable (lending cycle; ongoing upturn in housing sector), monetary policy is set to stay supportive, and the global economy should progressively start to regain momentum. Given that outlook, US GDP looks to have every chance of accelerating to slightly above 3% by the second half of next year.

The need for the US Federal debt ceiling to be raised by early March 2013 at the latest seems most likely to result in political upheavals dragging on throughout most of the first quarter Eurozone: austerity applying brakes to the economy The threat of a eurozone member state running out of funds to finance its public deficit noticeably receded following the ECB’s declaration of intent to purchase peripheral sovereign

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page5

BUDGETARY BELT-TIGHTENING ON THE CARDS FOR THE US IN 2013 Below, we have illustrated our estimate of the likely direct impact of the fiscal cliff on annual US GDP growth. 1.5

% pt Federal

1.0 0.5 0.0 -0.5

Our scenario: -1.0% pt

States & local authorities

-1.0

Total Full fiscal cliff: -3.0 %pt

-1.5 -2.0 -2.5 -3.0 -3.5

2008

2009

2010

2011

2012

2013E

Sources: Pictet & Cie, AA&MR

debt (via its Outright Monetary Transactions programme). As a result, systemic liquidity risk has diminished. The fine words will only be translated into deeds, however, if the member state in distress applies formally to the EU for a bailout. On this front, Spain has received no financial assistance as the Madrid government has not asked for it. But how long can Spain do without this help? Austerity measures geared towards lowering public debt are having a seriously adverse impact on the economy. This is being aggravated by punitive borrowing conditions for the private sector, the root cause being Spanish banks’ own troubles. Peripheral economies are being dragged down into a deflationary maelstrom and might end up being sucked into a Japanese-style ‘lost-decade’ scenario. These lame-duck economies are struggling after several quarters of recession in a row (five in Spain’s case, seven for Portugal, nine for Greece) with precious few glimmers of any recovery on the horizon. No country is seemingly being spared the rigours of the downswing. Even Germany is staring at the possibility of negative growth in the last quarter of this year. In such circumstances, countries’ huge debt mountains, coupled with ineffectual austerity programmes, may well prompt investors to ask some searching questions again. They could well decide to turn their backs once more on peripheral sovereign debt and banking shares. Yet again, Greece may provide another acid test of the euro’s resilience. The deepening budget deficit in 2012 casts serious doubt over the country’s longer-term

perspectives |november 2012

financing capabilities. Will Athens have to rely on regular transfers of funds from inside the eurozone? Will it have to go through with a second bout of debt restructuring? All these matters beg a number of probing questions about the foundations and architectural robustness of the whole eurozone edifice. Inklings of a slight rebound in China’s economy in Q3 2012 China’s GDP growth worked out at +7.4% y-o-y in Q3 2012, down from +7.6% for Q2, but the first glimpses of a tentative rebound were visible late on in the third quarter. Economic indicators have highlighted the solidity of the domestic economy despite the unsettled global economic backdrop. Growth in industrial output climbed back above 9% y-o-y in September, this encouraging trend-reversal driven by infrastructure projects and an end to destocking. Retail sales rose by 14.2% in September, compared to +13.1% in August. Export growth had been running barely above zero in July and August, but it picked up to almost 10% in September. In spite of the economic outlook brightening, the structural reasons for the slowdown will continue to hold sway. The root causes are several in number: over-exuberant investment in the past; diminishing efficiency of invested capital; low propensity to consume; blunting of China’s competitive edge relative to other emerging nations. The problems associated with these factors cannot be washed away and remedied by a classic economic reflationary programme. Furthermore, China is also entering a delicate transition phase as the team of leaders holding the top offices of state undergoes its periodic renewal. The succession process kicks off in November and will be completed in March 2013 when the new Prime Minister is appointed. The new leaders in Beijing will have to face the daunting challenge of steering the transformation of the economy towards a model with better balanced growth, reliant more on consumer spending and less on investment.

|5|

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page6

STRATEGY

Volatility possibly heading for a rise The weeks either side of the New Year are likely to be influenced by uncertainties surrounding the outcome of talks about tackling the fiscal cliff and raising the Federal debt ceiling in the US, which could heighten volatility on financial markets. Christophe Donay*, Chloé Koos Dunand, Jacques Henry, Laurent Godin and Yves Longchamp *With Wilhelm Sissener

FINANCIAL MARKETS Local-currency returns in % from financial markets. Data as of 31.10.2012 Indice

Since 30.12.2011

Previous month

US equities*

USD

S&P 500

14.3%

-1.8%

European equities*

EUR

STOXX Europe 600

14.0%

0.8%

Emerging-market equities*

USD

MSCI Emerging Markets

11.7%

-0.6%

US government bonds*

USD

ML Treasury Master

2.1%

-0.2%

US investment grade*

USD

ML Corp Master

10.5%

1.3%

US high yield*

USD

ML US High Yield Master II

12.9%

0.9%

Hedge funds

USD

Credit Suisse Tremont Index Global**

Commodities

USD

Reuters Commodities Index

Gold

USD

Gold Troy Ounce

5.6%

1.0%

-3.1%

-4.3%

9.5%

-2.8%

* Dividends/coupons reinvested ** End-September

Just as these specific risks about loom large, the ‘solvency risk’ component of eurozone systemic risk has not gone away. However, since ECB President Mario Draghi’s comments managed to tone down the ‘liquidity risk’ component of systemic risk, European equities have outperformed US shares. Risk factors to keep a close eye on Our approach to asset allocation based on various risk factors (see the ‘Topic of the Month’ article on page 12) pinpointed two key fundamental risk factors that have influenced how asset classes have performed over almost the past four years: (1) eurozone systemic crisis; (2) central banks’ monetary policies. Looking ahead to the next few months though, other risk factors may well bring their crucial influence to bear: the economic cycle and the corporate earnings cycle. Unlike the scarring on European bourses earlier this year, eurozone systemic risk left the S&P 500 virtually unscathed. Since late July though, in the slipstream of ground-breaking statements made by Mario Draghi (see the ‘Macroeconomics’ section), European shares (STOXX Europe 600: +7%) have outperformed equities on

|6|

Wall Street (S&P 500: +4%). Although solvency risk has not been dispelled, the liquidity component in systemic risk has lessened, and it should probably stay this way for a few more months to come. As the Fed and the ECB are likely to continue striving to push interest rates down close to or even below nominal GDP growth rates, financialmarket operators will, in all probability, switch focus to more conventional risk factors. As we move towards the turn of the year though, a couple of very specific risks are looming large. The fiscal cliff in the US and talks between parties to secure a deal to lift the Federal debt ceiling again could well spark fresh spikes in volatility on financial markets. Wait-and-see in run-up to US Presidential election Announcements made, first, by the ECB on 6 September and, second, by the Fed a week later on 13 September propelled equities on developed markets up to new year-highs. The third-quarter reporting season, however, did not deliver any major surprises powerful enough to extend the rally begun in June. US companies disappointed analysts somewhat for

the second quarter in a row. To date, 285 businesses have released figures. Although turnover and net profits did manage overall to come in above expectations by 0.9% and 3.6%, respectively, the quality of the results fell well short of satisfactory. The positive surprises came exclusively from the financial sector; if those are stripped out, turnover would have fallen some 0.5% short of expectations. So far, only 170 European companies have reported results: turnover figures have been encouraging after a string of disheartening quarters. As things stand, turnover and net profits have been around 5% better than expected. There have been two particularly striking features: (1) no obvious squeeze on margins; (2) unlike the US, the good surprises have not been delivered by financials. Emerging-market equities Asian markets slightly outperformed international shares in the third quarter, with the MSCI Asia ex-Japan benchmark up by 7.7% vs. the MSCI World’s 6.2% rise. Risk assets would appear to have benefited from investors’ rediscovered appetite for risk in the wake of the ECB’s, Fed’s and Bank of Japan’s practically simultaneous announcements of fresh quantitative-easing measures. Investors are still monitoring macroeconomic risks very closely, particularly the downgrading of GDP growth forecasts for emerging nations. The worsening climate for international trade could well curb Asian economies’ performance and put a squeeze on company profitability. The state of affairs is somewhat paradoxical though as the round of earnings downgrades in Asia (outside

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page7

Japan) has drawn to a close. Company profits are currently 10% above precrisis levels whereas Asian shares are priced at a 30% discount to their 2007 valuations. This does, however, mask a yawning gulf between defensive sectors on demanding valuation ratios and some bargain-basementpriced cyclicals. Past experience has taught us that, if earnings were to continue being upgraded, the rally by Asian equities ought to gather pace. For that to happen though, the markets would have to lean more towards positives from corporate earnings growth momentum and away from negatives focusing on systemic risks.

fiscal cliff and Spain’s application for a bailout could trigger upheavals on financial markets in the coming months: both would probably increase volatility on key exchange rates and result in investors’ aversion to risk mounting again. Recent movements in the euro and US dollar have clearly shown the dollar tending to be the prime beneficiary of any spike in risk aversion. Moreover, the US is still running ahead of Europe in the economic cycle. The dollar looks well placed to gain ground against the euro until all the doubts currently swirling around have been satisfactorily answered.

Across-the-board drop in commodity prices The Fed’s recent announcement of a third round of quantitative easing (QE3) in September had sent commodity prices climbing again, propelled upwards by hopes of a forthcoming upswing in the economy. Such hopes quickly fizzled out. During October, we witnessed a widespread fall in prices of commodities, including for gold. The final weeks of 2012 will doubtless see plenty of volatility as expectations veer between prospects of a recovery and the threat of a downturn in the world economic cycle. These pendulum swings should result in commodity prices moving up and down inside a broad band, similar to the pattern observed with crude oil whose price has been fluctuating between USD108 and USD118 a barrel. Euro under pressure in the run-up to the year-end Once the new President is installed in the Oval Office, economic issues will be thrust back centre-stage. The US

perspectives |november 2012

|7|

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:32 Page8

HEADLINE NEWS FROM AROUND THE WORLD

Upswing in US housing market confirmed The upswing being staged by the US housing sector has proved surprisingly robust. Most recently, figures for housing starts beat expectations. There is still a long way to go, however, before figures recover to their precrisis levels.

1% The UK returned to positive GDP growth after nine months in recession. GDP grew by 1% in Q3 2012 according to the Office for National Statistics. The British economy benefited from the London Olympics and a rebound in momentum after a bit of lull during celebrations to mark Queen Elizabeth II’s Diamond Jubilee.

+15% Housing starts in the US rose by 15% m-o-m in September, much faster than had been expected. The increase over 12 months worked out at almost 35% and the indicator is now 82% above its trough level recorded in April 2009. The encouraging uptrend is probably far from running out of steam though. Demand has been picking up, the stock of homes to be sold is at a low ebb and, even after the rise already recorded, housing starts would still have to more than double to climb back to their average between 2000 and 2005.

BThe Fitch Ratings agency placed Argentina’s long-term sovereign debt rating on ‘Rating Watch Negative’, implying a possible downgrade from B to B-, on account of financial risks facing the country.

2% Brazil has downgraded its projection for growth for the current year from 3% previously to 2%. Finance Minister Guido Mantega did, however, point out that the Brazilian economy is already starting to show signs of picking up again and is estimating GDP growth at over 4% for 2013.

|8|

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page9

100 Germany’s Ifo Business Climate index extended its downtrend to 100 in October, making that its sixth monthly decline in succession.

48.7 Manufacturing shrank in Norway in October, much to economists’ surprise. According to Statistics Norway, the seasonally-adjusted PMI fell from 49.1 in September to 48.7.

+7.4% China’s economy expanded by 7.4% y-o-y in Q3 2012 compared to +7.6% in Q2 and +8.1% in Q1, confirming that it is still gradually slowing down.

8% The Reserve Bank of India left its key interest rates unchanged in order to combat inflation, defying lobbying from the financial community to soften monetary policy. The repo rate, the interest rate at which the central bank lends to commercial banks, was left at 8% while the reverse repo rate, which banks benefit from on their deposits placed with the central bank, was held at 7%.

perspectives |november 2012

2.75% The Bank of Thailand cut its key interest rate by a quarter-point from 3.0% to 2.75%, its first reduction for nine months. The Thai central bank is looking to energise the economy and boost domestic demand.

|9|

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page10

ASSET CLASSES

Fiscal cliff could be the decisive influence The feed-through impact from central banks’ latest quantitative-easing plans has faded. Most asset classes have been fluctuating up and down since. Volatility might climb even further in the coming weeks depending on how negotiating the fiscal cliff is handled in the US.

Equities

Bonds

Corporate bonds

2012 shaping up to be a decent year

Safe-haven bonds losing more of their lustre

Good performance by corporates despite their demanding valuation

Unless a fresh shock hits home, stock markets in the developed world should hold onto gains accumulated since the outset of the year.

October gave German Bunds and US Treasuries a bumpy volatile ride. Over the next few weeks though, Greece’s ongoing financing troubles might well lend some renewed support to these safe-haven government bonds.

Corporates once again turned in a decent showing against a backdrop of volatility on safe-haven government bonds and falling share prices.

Volatility extended into October. Yields on the benchmark 10-year US Treasury bond rose from 1.61% at the start of the month to 1.83% by mid-October before drifting back to 1.70%. Looking beyond the short-term volatility, the phoney war that set in following news of the ECB’s Outright Monetary Transactions (OMT) and the Fed’s QE3 has tended to work against German Bunds and US T-bonds. The underlying uptrend in US bond yields, from their lows of 1.39% on 24 July, was not fundamentally derailed in October. The pattern was much the same for 10-year Bunds, with yields climbing by 30 basis points in total over the last three months. This trend on safe-haven bonds has, however, boosted peripheral eurozone sovereign debt, especially Italian and Spanish government bonds on which yields managed to stay below 5% and 5.75%, respectively. Movements in sovereign bond yields are highly likely to continue being influenced by what happens on the crisis-resolution front in Europe – primarily Greece’s fate, whether Spain applies for a bailout and banking union – and with regard to avoiding the fiscal cliff in the US. In the near term, Greece’s increased funding requirements, with even the possibility of more debt restructuring, could offer some respite and support to German and US government bonds.

The volatility that unsettled sovereign bonds in October failed to stop corporates setting more records: rates on investment-grade bonds reached 2.7% and those on high-yield paper dipped below 7%. Investment-grade corporates recorded a return of 1.3% for October and high-yield bonds +0.9% whereas both US Treasuries (-0.2%) and the S&P 500 (-1.8%) ended the month in the red. Just for a change, neither financials nor defensives were front-runners, their places usurped by insurers, media and energy. The laggards were technology corporates. The league table of year-to-date returns has the same look although the gaps have closed: equities’ gain has diminished a little to +14.3%, followed by high-yield (13.0%) and investment-grade (10.3%) corporates, with US T-bonds bringing up the rear (+1.9%). Sector-wise, banks and financials still lead the way. Events during the month confirmed once again one particular feature corporate bonds appear to possess. They provide protection for portfolios when markets are faltering even though valuations have already started to look demanding. Despite this characteristic, a close eye needs to be kept on this asset class from now on. If the big stumbling-blocks to solving the eurozone crisis or finding a deal to negotiate the fiscal cliff are removed, corporates could well lose their ‘star’ status to equities.

The markets are now into the run-up to the year-end. Barring serious mishaps, 2012 looks set to be a good year for equities in developed markets: S&P 500 +12% and STOXX Europe 600 +11% up to end-October. This excellent showing contrasts starkly with the sheer intensity of the euro crisis a year ago when the threat of Greece exiting the eurozone was at its height. Political measures and decisions made by central banks have served to lower the systemic liquidity risk premium penalising equity markets. On a less positive note, profits have been suffering over the year. Earnings forecasts for 2012 and 2013 have been downgraded by around 10% for European groups and by a smaller 4% for US companies. Estimates for current-year growth in profits now stand at +3.7% for the S&P 500 and –2.3% for the STOXX Europe 600, well below the figure of over +13% twelve months ago. Expectations for 2013 earnings are pitched at 10.5% for the US and 11.2% for Europe, with the US setting the pace in the downgrading process. In the case of Europe rather more than the US, whether these profit targets are met will hinge above all on the earnings to be contributed by financials and, secondarily, cyclicals. In the current climate, our defensive allocation looks the right approach.

|10|

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page11

Hedge funds

Precious metals

Currencies

“Don’t fight the Fed or the ECB”

Some disappointing returns in October

Consolidation on forex markets

For all their efforts, Bernanke and Draghi appear to have contributed to a change in themes played by hedge fund managers.

Prices of precious metals, as for other commodities, fell in October.

Diminishing systemic risk in Europe continued to underpin the euro, with forex markets overall exhibiting a fairly settled pattern of behaviour.

The HFRI Weighted Composite Index was up 1.2% in September, but midOctober estimates suggest a slight loss. All eyes though have been on the effects of September’s central bank actions. Draghi’s sovereignbond-buying promise encouraged many to trim or even close short EUR positions – with many macro specialists even turning to buy periphery bonds tactically. The ECB’s OMT is a game-changer for hedge funds, and they have adapted risk levels upwards. With less chance of a tail event occurring, long/short equity managers feel that stocks will begin to trade according to their fundamentals rather than macro factors – conducive to stock picking. The Fed’s QE infinity programme bolstered returns for structured credit allocations. Bernanke’s commitment to buy USD40 bn/month of MBSs, indefinitely, has reduced the yield on agency MBSs and will force investors to rotate into higher-yielding asset classes – creating more opportunities for hedge funds. With record inflows into the high-yield space, managers believe the best risk/returns are on the short side of the market.

perspectives |november 2012

Although the dollar price of gold has not returned to its record high for over a year, that is not the case for the price quoted in all currencies, most notably the euro. Early in October, the gold price in euros climbed 2.7% above its previous high from February 2012 before sinking back down. Moreover, this correction phase spread to all currencies and, indeed, to all commodities. The drop in prices for precious metals used for industrial purposes, like platinum and palladium, can be blamed on a resurgence in expectations of anaemic economic growth in the coming months. The bullion price would usually react and firm on the back of such fears, especially as the dollar was losing some value in October. The fact it corrected can probably be put down to profit-taking by a good many investors after the gold price’s 16% advance since May.

Currency markets were basically flat in October. The euro/US dollar exchange rate hovered around the EUR/USD1.30-threshold, with the euro just edging up in value a fraction (+0.8% in the month). The single currency was underpinned by diminishing systemic liquidity risk in Europe although the growth gap was angled in the dollar’s favour. Scandinavian currencies and the pound lost some ground against the euro, further demonstrating that fears about the euro falling apart have been subsiding. The Swiss franc was steady, range-bound between CHF1.2080 and CHF1.2120 to the euro. The yen had the hardest time of it in October, losing 2.3% against the dollar. Japan’s deepening trade deficit dented the yen and fuelled rumours of the Bank of Japan pressing ahead with further quantitative easing. In these market conditions with no obvious trend or direction, carrytrade and value strategies both registered negative returns: -0.4% and -0.2%, respectively.

|11|

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page12

TOPIC OF THE MONTH: ASSET ALLOCATION Delivering investment returns over time by pinpointing risk factors The history of asset allocation as part of the process of constructing investment portfolios has been influenced by a theoretical framework that has been constantly shifting. Models for computing expected returns and optimising risk/reward profiles in portfolios can be differentiated by the risk factors incorporated into them.

Countless academic studies and research have demonstrated that returns achieved by managing investments in a portfolio can be explained, primarily, by choices as regards asset classes and their respective weightings. Depending on the theoretical thinking referred to, individual returns generated by asset classes are influenced by one or more distinct risk factors. Academic researchers are still striving today to differentiate, by optimising as far as possible, the various risk factors that drive different asset classes. Although progress has been made over the last decade or so, especially in the aftermath of the 2008 financial crisis, a comprehensive theoretical structure has still not been erected. For our part, we have formulated our own proprietary approach geared towards risk factors.

The oldest model used for allocating assets in portfolios One of the cornerstone theories still used today for asset-allocation purposes is the Efficient Portfolio concept based on diversification first

Wilhelm Sissener Editorial Manager

|12|

put forward by Harry Markowitz in 1954. His approach to portfolio management was built on and refined by work done by William Sharpe in 1964 and John Lintner in 1965 who came up with the famous Capital Asset Pricing Model (CAPM). This was based on a single risk factor explaining expected returns: the risk premium. The risk premium is the extra return an investor demands from a diversified portfolio containing risk assets over and above the risk-free rate on sovereign debt. These two notable contributions to modern portfolio theory led to Harry Markowitz and William Sharpe being awarded the Nobel Prize for Economics in 19901. In his theory, Markowitz pinpointed the existence of a series of portfolios of asset classes which, for a given degree of risk, would maximise expected returns. William Sharpe’s contribution to this highlighted a single theoretical market portfolio that would deliver the best return on the risk taken. However, the assumptions underlying the theories of Markowitz, Sharpe and Lintner are neither homogeneous nor realistic. They start out from the position, for instance, that investors all have the same time-frames for their investments, that their investments do not incur costs and that they are able to lend or borrow money at the risk-free rate of interest. Moreover, the CAPM model calls for knowledge of a number of variables that are hard to evaluate. For instance, the risk premium can be neither accurately observed nor measured. Moreover, the most suitable risk-free interest rate to be used as a yardstick has perennially been the subject for heated debate.

Criticisms of CAPM and the multifactor approach The issues raised by the trio’s theories led to other academics formulating a critical analysis and endeavouring to explore new avenues. Richard Roll’s critique of the model in 1977 was the first formal onslaught on the empirical tests conducted for the CAPM. For instance, Roll pointed out that the market portfolio used by Markowitz was an approximation of the overall investment portfolio used in Sharpe’s and Lintner’s portfolio

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page13

bonds; (4) surprise shifts in the yield curve for sovereign bonds. A few years later in the early 1990s, Eugène Fama and Kenneth French from the ‘market-risk’ school of thinkers put forward refinements to the CAPM by bolting on two further risk factors, taking the total to three. Their analytical work focused on equity and bond markets. On stock markets, in addition to the risk premium, they pinpointed small-cap stocks and price/book value ratios as sources of outperformance. For bonds, they identified two different factors: one connected to maturity, the other to default risk. Over the period taken for their research, the model they constructed was capable of explaining 90% of the return, as opposed to 70% in the CAPM’s case. In the late 1990s, Mark Carhart, who had studied under Professor Fama, put forward a fourth risk factor to extend the Fama/French three-factor model: his suggestion was a market factor as well, momentum, which made allowance for past variations in securities prices.

optimisation theory. He also drew attention to the fact that the CAPM required a portfolio to be constructed taking due account of all feasible investments worldwide, obviously an impossibility in practical terms. Moving on from there, researchers developed new methods and methodologies. Two schools of thought came to the fore. The first went down the road of market factors; the second focused on economic fundamentals. Leading advocates from the latter school, Richard Roll,

perspectives |november 2012

Stephen Ross and Nai-Fu Chen, singled out four statistically significant macroeconomic parameters in a model – the Arbitrage Pricing Theory (APT) – that drew its inspiration from the CAPM to explain returns from a variety of asset classes. This quartet of factors are the following: (1) surprises in inflation; (2) surprises in GNP growth as measured using industrial production indices; (3) surprises in investor confidence as shown by default premiums priced into corporate

Need for a new framework for asset allocation However, risk-factor-based approaches to asset allocation evolve depending on the economic circumstances they are faced with. The state of economic affairs today is thoroughly different from the one that was prevalent before the 2008 crisis. In particular, the Great Divergence, highlighting the widening gap in trajectory between economic growth and government debt, has pushed swings in volatility regimes on financial markets up to new heights. Moreover, it has shifted the balance of correlations between asset classes. For instance, the classic 60/40 split, i.e.

|13|

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page14

TOPIC OF THE MONTH: ASSET ALLOCATION

60% in government bonds and 40% in equities, no longer delivers an adequate degree of diversification. As interest rates are close to zero, losses suffered on the equities position as a result of a crash on stock markets would no longer be offset by climbing bond prices. This new economic landscape called for a thorough rethink about the various risk factors that we employ, especially when it comes to the tactical asset allocation. From both a tactical and strategic perspective, our approach differs from both the conventional asset-pricing models outlined earlier and more recent academic theorising which, sadly, has

not yet been fully worked through. No consensus view in either academia or the professional world of high finance seems to have emerged on the matter. For example, astonishingly, new practices we have seen evidence of in the investment industry differ quite considerably: some have blatant shortcomings in terms of their theoretical rigour whereas others are just opaque and impenetrable. Our chosen method for allocating assets based on our approach geared towards risk factors seeks to remedy some of the drawbacks and enhance the risk/reward profile of portfolios. Our modelling approach will be presented in detail by Christophe

Contributors | Yves Bonzon, Christophe Donay, Jean-Pierre Durante, Bernard Lambert, Laurent Godin, Jacques Henry, Yves Longchamp, Kalina Moore, Wilhelm Sissener | Content completed on 31 October 2012 Translation | Stephen Barber, Daniel Steffen, Keith Watson Printer | Production Multimédia Pictet Paper | Printed on FSC-Certified paper Disclaimer | This report is issued and distributed by Pictet Group. It is not aimed at or intended for distribution to or use by any person or entity who is a citizen or resident of, or located in, any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. The information and material presented in this report are provided for information purposes only and are not to be used or considered as an offer or invitation to buy, sell or subscribe to any securities or other financial instruments. Furthermore, the information, opinions and estimates expressed herein reflect a judgment as at the original date of publication and are subject to change without notice. The value and income of any of the securities or financial instruments mentioned in this document can go up as well as down. The market value may be affected by changes in economic, financial or political factors, time to maturity, market conditions and volatility, or the

|14|

Donay in an article to appear in our Special Edition 2013 issue of Perspectives to be published before the year-end. 1

The Nobel Prize for Economics in 1990 was also awarded to Merton Miller in recognition of his contribution to the Modigliani-Miller theorem.

credit quality of any issuer or reference issuer. Moreover, currency exchange rates may have a positive or adverse effect on the value, price or income of any security or related investment mentioned in this report. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied, is made by Pictet Group regarding future performance. Instructions stipulated by the client as regards trading, transactions and investment constraints shall take precedence over, and may diverge from, the Bank’s overall investment strategy and recommendations. Portfolio managers are granted a degree of flexibility so as to accommodate the individual wishes and particular circumstances of clients. As such, the asset allocations specified in this report do not have to be strictly adhered to. Actual allocations to alternative, non-traditional investments (e.g. hedge funds) may exceed those mentioned in the grids herein provided that positions in traditional equities are adjusted accordingly. This publication and its contents may be quoted provided that the source is indicated. All rights reserved. Copyright © 2012 Pictet Group

perspectives |november 2012

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page15

KEY FIGURES

Global economy still looking brittle Growth in the world economy looks set to slacken to a historically slow tempo in the months ahead. This assumption, considering the seemingly slim chance of positive surprises surfacing in the US, Europe or even China, forms one of the central planks in our core scenario. Data in charts and tables dated as of 31 October 2012

MAIN ECONOMIC INDICATORS

INTEREST RATES Pictet estimates – (consensus)

GDP growth rates

2010

2011

US Eurozone Switzerland UK Japan China Brazil Russia

2.4% 1.9% 3.0% 1.8% 4.6% 10.4% 7.5% 4.3%

1.8% 1.5% 1.9% 0.9% -0.7% 9.2% 2.7% 4.3%

Inflation (IPC) Annual average, except year-end for Brazil

2010

2011

US Eurozone Switzerland UK Japan China Brazil Russia

1.6% 1.6% 0.7% 3.3% -0.7% 3.3% 5.9% 8.8%

3.2% 2.7% 0.2% 4.5% -0.3% 5.4% 6.5% 6.1%

2012E 2.2% -0.6% 1.0% -0.3% 2.4% 7.8% 1.3% 3.7%

(2.1%) (-0.5%) (0.9%) (-0.2%) (2.3%) (7.7%) (1.6%) (3.7%)

2012E 2.2% 2.4% -0.6% 2.7% -0.1% 3.0% 5.0% 6.7%

(2.1%) (2.4%) (-0.6%) (2.7%) (0.0%) (2.8%) (5.3%) (6.7%)

2013E 2.2% -0.1% 1.5% 1.4% 1.2% 7.5% 4.2% 3.6%

(2.0%) (0.2%) (1.2%) (1.2%) (1.3%) (8.1%) (3.9%) (3.6%)

2013E 2.3% 1.9% 0.4% 2.0% 0.0% 3.5% 5.6% 6.0%

US Eurozone Switzerland UK Japan China Brazil

Short (3-mth)

Long (10-yr)

0.1% 0.8% 0.0% 0.5% 0.1% 6.0% (1 year) 7.3%

1.7% 1.5% 0.5% 1.9% 0.8% 3.5% 9.2%

BOND MARKETS

(2.0%) (1.9%) (0.4%) (2.2%) (-0.1%) (3.4%) (5.3%) (6.0%)

Returns since 30.12.2011 CHF JPY USD GBP Emerging Debt (USD)

EXCHANGE-RATE MOVEMENTS (SINCE 30.12.2011)

EUR Emerging Debt (LC)

Against EUR

Against USD

Against CHF

NZD —

NZD —

NZD —

NOK —

NOK —

NOK —

GBP —

GBP —

GBP —

SEK —

SEK —

SEK —

CAD —

CAD —

CAD —

AUD —

AUD —

AUD —

CHF —

CHF —

HKD —

HKD —

HKD —

USD —

USD — JPY —

EUR — JPY —

EUR — JPY —

% -6 -4 -2 0

2

4

6

8

%

-6 -4 -2

0

2

4

%

6

High Yield USD High Yield EUR % -3

Energy

Agriculture

Brent

-6 -4 -2 0

2

Light: Returns for previous month

WTI Cocoa

4

6

MSCI World* S&P 500* MSCI Europe* Tokyo SE (Topix)* MSCI Pacific ex. Japan* SPI* Nasdaq MSCI Em. Markets* Russell 2000

USD

EUR

12.8% 14.3% 13.7% 0.3% 15.8% 14.4% 14.3% 11.7% 10.5%

13.0% 14.5% 13.9% 0.5% 16.0% 14.6% 14.5% 11.9% 10.7%

-30 -20 -10 0 10 20 30

Industrial metals

Gold

Copper -32.1

Silver

Zinc Platinum

Tin

Palladium

Lead %

perspectives |november 2012

27

CHF

GBP

12.3% 8.8% 13.8% 10.3% 13.2% 9.6% -0.09% -3.2% 15.3% 11.7% 13.9% 10.4% 13.8% 10.2% 11.2% 7.7% 10.0% 6.6% * Dividends reinvested

-30 -20 -10 0 10 20 30

US

Europe

World

9.1% 12.2% 7.9% 15.2% 15.7% 2.8% 2.7% 21.4% 8.9% 18.8%

11.7% 12.3% 7.7% -8.5% 12.2% -2.3% 2.7% 18.9% 11.2% 19.5%

7.7% 9.7% 4.2% 2.5% 14.0% 0.7% 0.2% 19.2% 9.7% 15.3%

% Precious metals*

Aluminium

-30 -20 -10 0 10 20 30

22

SECTORS Returns since 30.12.2011

%

17

Natural gas

Sugar -30 -20 -10 0 10 20 30

12

Returns since 30.12.2011

Dark: Performance since 30.12.2011

Corn

7

STOCK MARKETS

COMMODITIES Baltic Freight

2

%

* Pictet Index

Industrials IT Materials Telecommunications Health care Energy Utilities Financials Consumer staples Consumer discretionary

|15|

PERSP ANG 1112

Perspectives_Novembre 2012_EN_Octobre 08.11.12 08:33 Page16

Perspectives is also available to download. Sign up to subscribe and keep up-to-date online with our views on markets, the economy and key underlying trends on the Perspectives website: http://perspectives.pictet.com