Frail Fundamentals, Rising Liquidity: Where to Invest?

The 2012 outlook is fragile, but – in the absence of shocks – most economies will muddle through. Global growth will slow to less than 3 percent. In the developed world, structural issues, modest consumption, political impasse, and fiscal restraint will keep growth below potential. Emerging markets will grow above 5 percent, but below-trend. Yet, financial needs are higher than ever: this year, $8 trillion of sovereign and almost $1 trillion of corporate debt come due.

In recessionary Europe, while over-indebted states and over-leveraged banks keep financing each other, most countries need capital to finance budget and trade deficits. In 2012 alone, Italy needs $499 billion, France $368 billion, Germany $286 billion, the UK $165 billion. Greece and Portugal are insolvent and need debt-restructuring to kick-start growth. European banks need to refinance €230 ($304) billion in bonds in the first quarter of the year, and – given their subprime sovereign holdings – need between €115 billion (official stress-test estimate, by the European Banking Authority) and €300 billion (private-sector analysts’ estimate) to bring their Tier-1-capital-ratio to 9 percent by end-June. The US – likely to grow at about 2 percent, hence unable to reduce unemployment – needs $2.8 trillion, whilst its banks, still distressed by subprime mortgage assets, need capital to cover their European exposure. Japan – having suffered its first trade deficit since 1980, a ¥2.49 trillion ($32 billion) shortfall for 2011 – needs to refinance $3 trillion.

In Emerging Europe, the Middle East and Latin America investment and demand will weaken. Trade and investment, often intermediated by European banks, will suffer. In Eastern Europe, external debt is high, and accompanied by current account and fiscal deficits. Brazil faces $169 billion of maturing debt. In Asia, trade is resilient but final demand is not yet offsetting developed markets’ consumption. China – set to grow at about 8 percent, hampered by property-market weakness, capital outflows and trade links with Europe – needs to refinance $121 billion. India needs $57 billion.

Where will all this money come from? Global central banks. To avoid a credit crunch, pressures on interest rates, and disorderly defaults, monetary authorities in both advanced economies and emerging markets have injected massive liquidity, and will keep easing, by cutting rates and further engaging in asset-purchasing programs.

In the EU, the European Central Bank (ECB) has alleviated short-term sovereign and bank-financing stress, and possibly averted the collapse of a major financial institution, via aggressive monetary expansion. First, it purchased about €213 ($280) billion of government bonds to contain borrowing costs for Greece, Portugal, Ireland, Italy and Spain. Second, it cut its refinancing rate to 1 percent. Third, to ensure smaller banks access to inexpensive liquidity, it broadened – by possibly as much as €700 billion ($923 billion) – the pool of assets it accepts as collateral.  Finally, through long-term refinancing operations (LTRO) it allotted €489 ($655) billion worth of three-year loans to the banking system. On February 28, a second LTRO is expected to attract significant banks’ participation – between €500 and €700 billion. Further easing should be expected over the course of the year.

In the US, the Fed has committed to near-zero interest rates until late-2014, adopted a 2 percent inflation-target – which is likely to trigger further QE – and, via “operation twist”, is selling $400 billion of short-term government debt to buy longer-term securities.

The Bank of Japan (BoJ) has kept its key rate at or below 0.5 percent since 1995 to counter price-deflation. In early-2012, it set a 1-to-2 percent inflation-target, and, by buying more long-term government bonds, it expanded its asset-purchasing program to ¥65 trillion ($833 billion) and possibly limited the appreciation of the yen.

The Bank of England (BoE) is keeping its main rate at a record low 0.5 percent, and recently increased its government-bond purchases by £50 billion ($79 billion), bringing the total amount since the program began in 2009 to £325 billion ($511 billion), roughly 20 percent of UK gross domestic product.

In emerging markets, central banks have been cutting rates. Brazil and India have been easing more aggressively than expected.

Going forward, given slowing growth and global fiscal constraints, further monetary easing is the only policy-bullet left in order to try to reduce long-term interest rates, spur spending and investment, and make exports more competitive by weakening currencies. However, solving a debt crisis with more debt poses risks. The ECB massive liquidity provision might end up aggravating rather than reducing the interdependence of banks and sovereigns. In other words, monetary policy alone cannot save the day, it can only buy time by addressing liquidity constraints. If solvency is the issue – and sovereign and banks’ solvency is not yet a given – monetary easing can do little to restore growth.

Over the last five years, the combined balance sheets of the eight world’s main central banks (US Fed, People’s Bank of China, ECB, BoJ, BoE, Germany’s Bundesbank, Banque de France, Swiss National Bank) tripled from $5 to $15 trillion. Still, the global economy has yet to benefit, because banks play safe, and accumulate liquidity reserves. To meet stricter capital requirements, EU and US banks sell assets and shrink their loan portfolios. Instead of lending to firms and households the money they borrowed from the central bank – a move that would increase their profits, stimulate the recovery and reduce unemployment – they stockpile it back at central banks. In Europe, the financial sector is holding over €464 billion of excess reserves in the ECB’s 0.25 percent deposit facility, while lending growth is slowing sharply. In other words, the monetary transmission mechanism of credit to the economy is damaged. The risk is a credit crunch and a deceleration in economic activity, with falling inflation, precisely the conditions for further easing. The consequences of this self-feeding process are untested.

If uncertainty does not dissipate soon, where to invest? The year started with encouraging US economic data. In the EU, massive ECB support lowered sovereign yields and spreads, unfroze interbank lending, and reduced risk of disorderly defaults in the banking system. China and emerging markets slowed down, but did not hard-land. With valuations below historical trends, risk-aversion declined. For the first time in decades, the earnings yield (annual profits divided by price) in the Standard & Poor’s 500 index (S&P500) rose above 7 percent, about 5 percent above the 10-year US Treasuries (10Y-UST) rate. Also, more than 40 percent of the stocks in the S&P500 yielded more in dividends than the 10Y-UST in interest. Investors’ confidence rose and the hardest-hit assets became sought after. In emerging economies, short-term portfolio-flows chased high-yield, reflating asset in Asia and Latin America. Quickly, liquidity galvanized investors seeking higher returns. Although thinly-traded, global equities and commodities surged.

For the rally to last, a healthy global recovery and rising company earnings are needed. But the whole world is slowing down. The US economy is showing signs of deceleration and could enter a soft patch. Consumers are cautious. Europe – UK included – is sliding into recession. China and India are unlikely to inject a sizeable stimulus in their economies. Going forward, growth will remain challenged. In advanced economies, household, financial-sector and public-sector deleveraging, spending cuts and reforms are needed and upcoming. Fiscal consolidation will accelerate disinflation, and – as buyers anticipate lower prices – consumption will decline.

“Tail risks” – low-probability, high-impact events that could have systemic consequences via negative feedback loops – could materialize, hampering the real economy and investor confidence. Indeed, global unemployment affects 200 million people (up 27 million since the start of the crisis) and could spark unrest. The Arab turmoil and Iran nuclear ambitions are unlikely to be frictionless. The Eurozone’s democratic deficit, rising sovereign risks and ongoing debt restructuring – where a Greek deal is likely to lead to a Portuguese one – are sources of stress and possibly contagion. Policy mistakes, due to wait-and-see attitude or political deadlock, could induce a recession. Banks, in need of capital and allergic to regulatory reform, will foster financial sector jitteriness. Global politics looks challenging, with presidential elections in the US, Russia, Egypt, Yemen, and Venezuela, parliamentary elections in India, Iran, Egypt, Libya, Jordan, and Tunisia, the leadership transition in China and North Korea’s succession. Pakistan and Afghanistan could also contribute to geo-political instability.

As a result, corporations are on hold, lacking confidence to make significant business and investment decisions, since sales, profit margins and corporate earnings might suffer.  The market seems to have moved ahead of fundamentals, and a correction looks likely.

In 2012, because of excessive liquidity and high uncertainty, stock markets are likely to remain highly volatile. Investors might focus on news and events rather than longer-term trends. Given the slow-growth, disinflationary outlook, a fast “reversion to the mean” of returns is improbable. Indeed, stocks could be cheap because, as happened in Japan, they discount a deflationary trend. Taking fundamental directional bets (i.e. via long-only funds) is likely to prove disappointing. Earnings growth will soften, especially in emerging markets. Financials are likely to suffer. Investors will privilege strong balance sheets and value. Blue chips income-producing multinational brands will do well, as a significant share of their revenues comes from emerging markets. Small luxury companies, healthcare providers and the consumer sector are likely to generate returns. US stock markets are likely to outperform.

Core sovereign bonds (UST and German Bunds) might benefit from risk-off episodes, slowing economic growth and a reduction in long-term interest rates. Still, in absence of systemic shocks, high-yield corporate credit might perform well and emerging country bonds denominated in local currencies could deliver even higher returns. Inflation-linked bonds show more risk than returns.

The unfolding of the Eurozone crisis and the ongoing ECB monetization should weaken the Euro. If a tail risk materializes, investors will retreat to the USD, still the world’s primary trading and reserve currency and a global safe haven. The Swiss franc is likely to maintain it purchasing power.

With respect to the past decades, investors face a very different, and more difficult, investment environment. The probability of future financial shocks, and black swans, is high. Capital preservation via a defensive asset allocation is priority. Over the next couple of years, cash could work as both an insurance against sharp downturns and the required seeding-capital to quickly size opportunities. Still, in the longer-run keeping liquid portfolios will result in low returns. Illiquid assets, such as private equity and real estate are to be considered, but only if fully understood and professionally executed. In a few years, looking back to this post-crisis period with the benefit of hindsight, it is likely that unusual portfolios – less liquid and more volatile, thus considered of lower quality today – will have performed better than accepted ones.

The indicative portfolio shown below attempts to crystallize the above.