JULY 2010                                                                           Dowload PDF Version

Are we Moving off Trend?


We recently emailed Robert Shiller, the well-known Professor of Economics at Yale University, trying to get clarification on a few valuation issues. The email response which we received, however, raised a number of further concerns. His reply cast doubt on a reversion to trend stating that it was ‘controversial, with some econometricians saying that the apparent trend-revision is spurious…’

   
Source: Credit Suisse


The above graph illustrates the point. Between 1916 and 1921 there was a structural shift down in earnings before a new (and lower) channel of earnings was established.

We have to analyse whether we are currently experiencing a similar movement. The markets seem to be pricing a cyclical/trend-reverting recovery, however, there are fundamental issues which make this recession and recovery different. We must be aware of how to react if indeed we are moving off trend whilst guarding against undue pessimism.

In this quarterly letter we briefly examine the fundamental issues, how they affect the global markets and how we are looking not only to protect portfolios in the event that ‘it is different this time’ but also trying to capitalise on the medium and long-term opportunities that these changes will create.

STRUCTURAL ISSUES

A number of these are longer-term trends and are brought to the fore in times of uncertainty while others are directly related to the global slowdown.

  1. The rise of China, India and Brazil
    This could also read ‘the decline of the American empire’. This trend is clearly now fully established and is the most powerful engine for global change; political systems and power relationships are re-aligning. Although the emerging market consumers are not yet powerful enough to drag the world out of this recession it is clear that they will be the drivers of this century.

  2. Demographics
    By 2030 the percentage of the world’s population over 65 years old will increase from its current level of circa 12.5% to circa 20%. This increase will take place during a period of strong global population growth and will mostly be caused by the aging of the Western world and Japan. The implications of this are numerous and they are made worse by the     fact that the aging population has, generally speaking, lived off debt; a debt burden (not to mention pension liabilities) that has to be shouldered by a smaller number of people.

  3. Global Debt Levels
    It is important to consider not only the massive debts that have accrued in the ‘developed’ economies but also the lack of debt in the ‘developing’ nations.











  1. Households and governments in developed countries borrowed massively in order to consume now and pay back later. They may have hoped to continue to borrow on the expectation of continued and rising prosperity but now it is pay-back time and it will be people’s standard of living which is hit.

  2. Global Aggregate Demand
    An equally important factor is the lack of debt and internal consumption in the emerging economies. These economies produce for export not internal consumption and, now that the developed consumer can no longer buy from them, the lack of global aggregate demand is very clear. Bill Gross, founder of Pimco and one of the world’s largest mutual     fund managers and bond experts, likens these emerging economies to young giraffes on spindly legs: having great potential for growth but also for falling over as they do not yet have the confidence to reach for the ‘higher leaves of internal consumption’.

  3. Employment
    Unemployment in the USA (and this is reflected similarly in other developed countries) is now becoming a structural issue. It is closely linked to many of the themes above but essentially it represents the large amount of high quality and high-productivity labour that will be coming ‘online’ from Brazil, India, China, Brazil and other emerging countries. These new jobs are not currently directed at satisfying internal consumption of these emerging economies but instead are displacing jobs in the USA, Japan and Europe. The chart below shows how employment during the recent recession is following a different pattern to earlier ones.    











MARKET OUTLOOK

In spite of all the fundamental issues highlighted above it is still not at all evident that a double-dip recession is inevitable. However, we certainly do not agree that it is impossible and we must assess investment scenarios that would result.

The stakes are incredibly high at the moment and a double-dip would be massively deflationary. Western Governments would surely be tempted to resume quantitative easing and the recovery could become a crisis. The most positive scenario is that as government stimulus is removed the level of growth in the economy, though extremely low, can be sustained by a gradual recovery in private income; in basic terms the economy will ‘muddle through’.


  1. Equity Markets
    The signs are mixed. Valuations do not look over-stretched as long as earnings hold up; unfortunately, there are signs of some earnings starting to be downgraded.

    After the slide in markets of Q2 there seems to be fewer reasons to sell equities now. On a technical basis, however, a number of the indices have either broken important technical levels or are threatening to do so. Therefore we need to keep a very close eye on this in order to be ready not only to reduce exposure but also to get back into the market should the technical breakdown lead to a buying opportunity.

    The most important point is that clients will need to re-assess their return expectations for equities for the foreseeable future. As Bill Gross puts it: “The markets stand on the ‘threshold of mediocrity”. The chart on the following page illustrates the key question that we asked in last quarter’s newsletter, namely are we in a new bull-market or in a     continuing bear market? We tend towards the latter opinion which means that we need to have a very disciplined risk management strategy in place for client portfolios during this coming investment period.

    Corporates entered this crisis in very different states, some with a great deal of cash on their balance sheets, some with leverage. Therefore there is an opportunity to stock pick individual names and it is also likely that there will be a increased level of M & A activity as the strong buy out the weak.

    The current ‘trade of the year’ is to buy companies that can be classed as ‘franchise’ or ‘platform’ companies. This basically means buying western companies which operate globally and derive a considerable proportion of their revenue from the emerging markets. We also like this trade and have created a short-list of funds which exploit this     opportunity.

   









  1. Hedge Funds
    The investment environment should provide hedge fund managers with good opportunities. We expect certain strategies to perform better than others. In particular we expect long-short equity managers to perform well, credit and distressed managers to continue to have positive results and event-driven strategies to prosper.

    At Clarmond we will tend to invest in hedge funds through fund-of-fund or multi-strategy funds. We have recently met with some very impressive and newly formed funds to which we will be making allocations to over the remainder of the year.

  2. Gold
    Gold enjoyed good performance in the quarter, rising by 12% (in US$ terms). We have to admit to having largely stood aside from the gold rally; what moves the gold price? Is it inflation? Is it a flight to safety in the face of an uncertain world? Is gold a currency? It probably moves because of all three factors (and others besides) and therefore should the double dip scenario unfold then it is certainly an asset that would benefit, not only from the financial uncertainty that would follow but also from the inflation that would eventually be created as the governments restart printing money.

    Portfolios should get exposure to real assets in some shape or form and we are researching gold, timber, property, commodities and inflation-linked bonds.

  3. Currencies
    Getting on the right side of the larger currency moves may well be the only way to make     ‘proper’ returns over the next decade. We will be carefully considering the best way for     clients to diversify away from the major currency groups into not only into commodity     currencies (Canadian Dollar, Norwegian Krona, Australian Dollar), but also into     emerging market currencies.

    Currencies tend to move in long duration trends, but, when they do shift, the change in     rate can be rapid. Bearing in mind the issues outlined earlier in this letter then we could     make an argument for the weakening of the US Dollar and the Euro and the     strengthening of a range of secondary currencies.

CONCLUSIONS

  1. We may avoid a double dip though this does not mean we will stay on the same earnings trend. In this event the equity markets would pull back;

  2. Be prepared to alter portfolios rapidly should circumstances suggest the recovery has failed;

  3. There are structural issues that will resonate for more than the next decade;

  4. Remain underweight/neutral on equities and stay vigilant in the short term in relation to the deteriorating technicals;

  5. Favour ‘franchise companies’ funds;

  6. Look for high quality Long-Short, Alternative and Multi-Strategy Fund-of-Funds which have learnt from the 2008/09 problems;

  7. Gain exposure to ‘real assets’ in some form; and

  8. Diversify currency exposures.


Please do not hesitate to contact Christopher Andrew:

Christopher Andrew       
ca@clarmond.co.uk                       
Tel: +44 20 7060 1400

 

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