10 Oct 2011
James M. M. Edwards, Chief Investment Officer – Eurofin Capital
The September Quarterly Investment Committee is always a major event for me. In many ways I think of September as the beginning of the year, linked as it is to the new school or university term. This year, I suspect many want September to be the start of a new year, so disastrous and difficult have the first 9 months of 2011 proved to be. As I write (20th September) the S&P 500 is down -4.3 %the Eurostoxx is down -23.8 %, the HFRX Global Hedge Fund Index -6.7 % and Equity Hedge Index -15.5 % (both as at 16th September), in fact not a single one of the HFRX sub-styles that we track was positive year-to-date! Of course, many might argue that it could be a lot worse and those holding a basket of European bank stocks would probably be nursing losses of between 40 and 50 % year-to-date, so devastating has the turmoil in Europe been. This turmoil in Europe has inevitably had an impact globally as investors appear glued to the soap opera like travails of the European family, awaiting each chapter with a combination of disbelief and disappointment.
Against this background, and knowing that our choices of asset allocation would be critical for the final quarter of the year, we had a very active Investment Committee. The deliberations of our Top Down process are in the second half of this paper, and the conclusions reflect the somewhat schizophrenic nature of the world as we see it. Critically we have changed our positioning in terms of where we believe we are currently sitting in the economic cycle, moving the arrow backwards to a period of slowdown. All the current and more importantly the forward looking indicators point to a global slowdown, with no geographic zone immune, although the absolute levels of growth remain quite wide.
Notwithstanding this view, we remain very reluctant to add to any fixed income allocation, and remain stubbornly underinvested in this asset class. The reasons are simple: real and nominal yields don’t make sense as an investment proposition unless you are forecasting a 1930’s depression, which we are not, and which we view as unlikely. Secondly, broad equity market valuations, in particular in Europe, are now firmly in single digit territory despite generally very healthy corporate balance sheets. In fact many large corporations are almost too healthy, underleveraged, cash rich, bereft of ideas to the extent that even Mr Buffet himself is buying back his stock, or in the case of Microsoft massively increasing the level of their dividends. (As an aside, these actions say more about how uncomfortable some of these corporations feel about the banks where their cash is on deposit, than on the valuations of potential target companies.)
As my colleague Laurent Chevallier commented recently in an interview, a big problem for investors in recent months has been that “low probability scenarios happen every week” and this is making it very challenging for investors to size positions and appreciate the level of risk they have within a portfolio. Another reason therefore for our rather unorthodox portfolio allocation, small bond positions and large equity allocations supported by cash and some hedge funds. Cash, because we want to buy on dips and it acts as a very efficient volatility break, and hedge funds because they are collectively so underinvested, using very little of their risk budgets that we would expect them to react far quicker than us. Interestingly, this is where the Q4 story comes into play, and why I highlighted how disappointing all of these strategies have been in 2011. Total return funds are rewarded on their absolute performance, not on their relative performance, and as things stand at the moment, they will be earning a management fee, but no performance fee, which is correct as we want to reward success.
Whilst it is unscientific, I have been looking at the performance of the HFRX Global Hedge Fund Index and the Dow Jones Credit Suisse Hedge Fund Index, since 2001, and in both cases they have only experienced a negative 4th Quarter once, in 2008. Obviously there are many explanations as to why this is the case, but one of them I suspect is the issue of absolute performance, and being rewarded for success, not for relative performance. These managers will work hard to generate positive returns.
Finally to our equity call which appears slightly at odds with our Macro view that we are in slowdown. Everyone is forecasting 2012 global and regional growth to be lower than 2011. We think equity markets are already pricing this expected slowdown. P/e multiples for the S&P 500, the Eurostoxx and the Hang Seng have fallen by 15, 20 and 22 % respectively between our Investment Committee in January 2011 and our September committee. These changes are broadly similar whether you look at Current Year or Next Year estimates and are based on consensus analyst forecasts as compiled by Bloomberg. Of course we know that these can fall further, but barring the banking sector, we think many of the large cap companies are in robust health to weather slowdowns, and can pay dividends!
I haven’t talked about Greece, or the mess that politicians in Europe seem to be making of the process of stabilising investor fears, because the markets are already so far ahead of them. As with Argentina in 2002, the default was so well sign-posted, a train wreck in slow motion, that when it eventually took place, markets rallied. I would not be surprised if we experience a similar reaction this time as well. What it does mean is that market volatility as measured by VIX, or MOVE or whatever other measure will stay elevated until the event has taken place, but investors should stay alert and be ready and positioned to act.
The September Quarterly Investment Committee is always a major event for me. In many ways I think of September as the beginning of the year, linked as it is to the new school or university term. This year, I suspect many want September to be the start of a new year, so disastrous and difficult have the first 9 months of 2011 proved to be. As I write (20th September) the S&P 500 is down -4.3 %the Eurostoxx is down -23.8 %, the HFRX Global Hedge Fund Index -6.7 % and Equity Hedge Index -15.5 % (both as at 16th September), in fact not a single one of the HFRX sub-styles that we track was positive year-to-date! Of course, many might argue that it could be a lot worse and those holding a basket of European bank stocks would probably be nursing losses of between 40 and 50 % year-to-date, so devastating has the turmoil in Europe been. This turmoil in Europe has inevitably had an impact globally as investors appear glued to the soap opera like travails of the European family, awaiting each chapter with a combination of disbelief and disappointment.
Against this background, and knowing that our choices of asset allocation would be critical for the final quarter of the year, we had a very active Investment Committee. The deliberations of our Top Down process are in the second half of this paper, and the conclusions reflect the somewhat schizophrenic nature of the world as we see it. Critically we have changed our positioning in terms of where we believe we are currently sitting in the economic cycle, moving the arrow backwards to a period of slowdown. All the current and more importantly the forward looking indicators point to a global slowdown, with no geographic zone immune, although the absolute levels of growth remain quite wide.
Notwithstanding this view, we remain very reluctant to add to any fixed income allocation, and remain stubbornly underinvested in this asset class. The reasons are simple: real and nominal yields don’t make sense as an investment proposition unless you are forecasting a 1930’s depression, which we are not, and which we view as unlikely. Secondly, broad equity market valuations, in particular in Europe, are now firmly in single digit territory despite generally very healthy corporate balance sheets. In fact many large corporations are almost too healthy, underleveraged, cash rich, bereft of ideas to the extent that even Mr Buffet himself is buying back his stock, or in the case of Microsoft massively increasing the level of their dividends. (As an aside, these actions say more about how uncomfortable some of these corporations feel about the banks where their cash is on deposit, than on the valuations of potential target companies.)
As my colleague Laurent Chevallier commented recently in an interview, a big problem for investors in recent months has been that “low probability scenarios happen every week” and this is making it very challenging for investors to size positions and appreciate the level of risk they have within a portfolio. Another reason therefore for our rather unorthodox portfolio allocation, small bond positions and large equity allocations supported by cash and some hedge funds. Cash, because we want to buy on dips and it acts as a very efficient volatility break, and hedge funds because they are collectively so underinvested, using very little of their risk budgets that we would expect them to react far quicker than us. Interestingly, this is where the Q4 story comes into play, and why I highlighted how disappointing all of these strategies have been in 2011. Total return funds are rewarded on their absolute performance, not on their relative performance, and as things stand at the moment, they will be earning a management fee, but no performance fee, which is correct as we want to reward success.
Whilst it is unscientific, I have been looking at the performance of the HFRX Global Hedge Fund Index and the Dow Jones Credit Suisse Hedge Fund Index, since 2001, and in both cases they have only experienced a negative 4th Quarter once, in 2008. Obviously there are many explanations as to why this is the case, but one of them I suspect is the issue of absolute performance, and being rewarded for success, not for relative performance. These managers will work hard to generate positive returns.
Finally to our equity call which appears slightly at odds with our Macro view that we are in slowdown. Everyone is forecasting 2012 global and regional growth to be lower than 2011. We think equity markets are already pricing this expected slowdown. P/e multiples for the S&P 500, the Eurostoxx and the Hang Seng have fallen by 15, 20 and 22 % respectively between our Investment Committee in January 2011 and our September committee. These changes are broadly similar whether you look at Current Year or Next Year estimates and are based on consensus analyst forecasts as compiled by Bloomberg. Of course we know that these can fall further, but barring the banking sector, we think many of the large cap companies are in robust health to weather slowdowns, and can pay dividends!
I haven’t talked about Greece, or the mess that politicians in Europe seem to be making of the process of stabilising investor fears, because the markets are already so far ahead of them. As with Argentina in 2002, the default was so well sign-posted, a train wreck in slow motion, that when it eventually took place, markets rallied. I would not be surprised if we experience a similar reaction this time as well. What it does mean is that market volatility as measured by VIX, or MOVE or whatever other measure will stay elevated until the event has taken place, but investors should stay alert and be ready and positioned to act.
