The rule "You don't need to predict the rain, but it counts knowing how to build the Ark", as expressed by Warren Buffett (given his strong interests in the insurance sector) clearly also has wider implications on the structuring of an investment. If we talk about global investments, trying to predict the next downpour can be futile, but investors would still do well to think about the type of ark to build in the event of structural "weather" changes, especially those generated by policies, regulations and cycle dynamics economic.
As an investment house, we strongly believe in the value of building arks, but we go one step further by thinking about building “fit for purpose” fundamentals-based solutions that can weather the storms that changing economic cycles, policies and regulations can trigger.
Weather Check (I) – Global Recession on the Horizon?
Given the sharp moves in risky asset markets since the beginning of the year, the first weather check is to assess the likelihood of recession in the world's major economic centres. Starting with the US, labor market dynamics continue to look healthy, despite recent lower-than-expected nonfarm payrolls data. Unemployment fell and wage growth showed signs of accelerating. The manufacturing sector, together with the economy's investments (an aspect captured by high-frequency indicators on the type of durable goods orders) have been the main source of downward revision in the recent moment of growth, which can be explained in light of the drastic decline of oil prices. However, the consumer side of the economy remains resilient and indicators such as auto sales show solid underlying trends. More importantly, there are no signs of an increase in non-performing loans (NPLs) or of a real reduction in credit, which would indicate worrying mechanisms of credit crunch (figures 1 and 2).
Turning to the Eurozone, the gradual trend towards a recovery in activity remains intact and the granting of credit, especially in the domestic sector, continues to improve. Economic survey data showed signs of a reversal in January (main driver behind the recent slump in surprise indicators), however we think this is more closely related to market developments than underlying fundamental issues given the continuously improving credit conditions. Based on the current level of several activity indicators (Figure 3), credit supply trends and the steady improvement in corporate profitability, we believe that the probability of a Eurozone recession in the next 6-12 months remains quite low .
Finally, indicators of real activity in China remain weak. However, it is clear that the deterioration in trend has started to level off (eg Caixin China Manufacturing PMI remains well above the lows seen in September 2015 and within the recent range). In terms of hard data, there have certainly been some rays of light in commodity imports – copper has hit a record high, as shown by the latest data. After the panic in China's asset markets in early January, the PBoC appears to have been pumping in additional liquidity, a hypothesis that will likely be confirmed by data on the money supply and new yuan lending to be released in the coming days. Overall, fundamental results show no signs of an imminent recession in the global economy. Pockets of weakness related to the Chinese slowdown and struggling commodity sector are still visible in the activity numbers, but credit cycle dynamics and services business trends nationwide show little possibility of an imminent recession in major centers global economics.
Weather Control (II) – Increased systemic risks
It is worrying that, despite the low probability of a recession based on hard data trends, recent price developments in risky asset markets show a sharp tightening of financial conditions (figure 4) which, if it persists, could weigh on economic results real. This connection is even more important in the current cycle, given the large role of monetary policy (and, by extension, financial conditions) as a key source of stimulus in many advanced economies. Furthermore, the heavy pressures on the European financial sector (especially in the credit space) highlight a change in the nature of the current sell-off: today it seems rather driven by systemic fears rather than fear of an economic recession (with the epicenter in China and in commodities), as was the case in January. For example, the CDS of major European banks are now close to the dark days of 2011/12, when the main sources of fear were the breakup of the euro and a possible currency redenomination, which is difficult to explain only in light of exposure to the energy of the financial sector. Central banks have certainly flooded the financial system with excess liquidity since 2012, with the specific intent of protecting the financial sector from margin calls induced by liquidity issues.
In terms of the risk of a real liquidity event, as highlighted by a recent report by Goldman Sachs, several standby instruments (such as TLTRO operations) remain untapped and, more importantly, the funding markets (both USD and euro) show no signs of an effective reduction in liquidity. Given the market movements, it is now certainly much cheaper for many major European banks to get long-term funding from the ECB than from the markets, as indicated by the latest reports that Deutsche Bank is considering buying back a significant amount of its senior note . In this context, we believe we are today facing a serious liquidity "accident" in the bond/credit market, in which imitative behavior (so-called herding) and the structural deterioration of the availability of microliquidity are leading to sharp movements in the credit markets ( theme that we have constantly addressed in the last 15 months). Superficially, this would appear to be a systemic risk issue, but we think the nature of the beast we are dealing with is quite different from 2008/9 or 2011/12.
Weather Check (III) – Central Banks Head for New “Liquidity Rain”
First, the longevity of today's turmoil will depend on how major central banks react to current developments. Historical data shows us that central bank easing measures (or credible promises to do so) tend to be most effective when valuations are low and stress is high (eg, early 2009 and 2012). Looking at real economic results, one can question the long-term effectiveness of QE and negative interest rates; however, given the availability of liquidity that easing measures generate, the impact on liquidity conditions and, by extension, on financial assets is beyond dispute. Given the rise in systemic risks and the dramatic tightening of financial conditions we have seen in recent weeks, we believe major central banks will implement sizeable easing measures to mitigate the negative effect on economic growth and inflation. In the case of the ECB, we expect a 20 bps rate cut at the next meeting and an expansion of the QE program in terms of both scope and duration, accompanied by the promise of further similar measures if necessary. We are also likely to review the broad range of protections available to central banks to support the financial system. In the case of the Fed, we expect a very cautious approach, with rate hikes temporarily shelved given the sharp tightening in financial conditions. The PBoC is already pumping liquidity into the national system and recent reserve data shows signs of stress, but not panic as at the end of last year. Finally, we expect Japan to further ease monetary policy in the coming months to ensure its relative position remains in line with global changes.
Building an Ark (I) – European equities are highly sensitive to ECB policy dynamics, but grasping the differentiation is essential
While we are correct in thinking that the current level of stress in global risk assets is driven by a liquidity crash in the credit market, we also believe that coordinated central bank easing could short-circuit the negative spiral. Structurally, as we have argued several times before, the impact of liquidity-induced storms is likely to remain significant given the changes in the regulatory environment. But these accidents are nothing more: they are accidents. Indeed, the global environment of disinflation and deflation means that central banks can continue to use fresh liquidity injections to push investors into risk-taking when valuations become attractive given liquidity.
To highlight the power of central banks over risky assets, we show below the dynamics of European securities markets before and after major monetary policy developments (Figures 5, 6, 7 and 8). With the price-to-book price of the MSCI Europe index at its 2011/12 low (Display 9) we think valuations today factor in sufficient stress for central bank easing measures to have an immediate and sustained effect.
In terms of implementing this currently contrary view, we think it is the quality of the “ark” that can be built that counts. We believe that sector/investment style differentiation will continue to be a strong theme, alongside the prevalence of idiosyncratic factors, and will determine both the volatility and long-term return profile of any exposure, especially given the reality and current disruptions of liquidity have structural roots. We therefore think that simple beta is not suited to address today's challenges and that a solid management skill can go a long way in addressing the complex global economic and financial interconnections.
Building an Ark (II) – Emerging markets fixed income offers yield and valuation support, but recent challenges push towards a fundamentals-focused approach
With negative interest rate profiles fully intact in major economic centres, further central bank easing is likely to be a major theme in 2016. At a high level, it would create an environment conducive to the need for diversification (given tangible queues) and a “prudent” search for yield. In terms of investment construction, that would mean looking at non-traditional sources of return (such as uncorrelated cash and strategies) and/or better implementation, where beta still offers some long-term return potential. On this last point, with the Chinese slowdown accompanied by the collapse in emerging market asset prices over the past two and a half years, EM assets have undoubtedly come under severe pressure. However, IIF capital flow data shows that international investors are now systematically underweight emerging markets, at a time when the external profile of several developing markets is starting to improve (Figure 10), while indicators based on valuations are starting to show signs of a deep gap between fair value and current values (especially if we are talking about FX). As for China, we still think fears of a financial meltdown are exaggerated, given the wide range of protective measures available to the authorities and which can be used to halt citizens' loss of confidence in the local currency (Emerging Markets: Challenges versus Opportunities).
Against this backdrop, we think that the extra liquidity available in advanced economies will likely find its way to emerging markets in the coming months, given less foreign ownership and the attractive yield profiles offered by the asset class in a world of low interest rates. deep and widespread negative interest (Figure 11). This type of cushion also exists in the emerging markets equity space, where we see attractive valuations, especially when compared to developed markets.
