War against deflation
Although it may not currently be fashionable to admit it: we are fundamentalists. This relates to our investment and research, not ideological, approach. The first step in every investment decision is the analysis of the key long-term drivers of an investment. We then confront our findings with the consensus view. When our view differs, there are two possibilities: we have made a mistake, or there is an investment opportunity. Market sentiment and timing is only a third consideration. Having a small and focused team helps in this approach, because strong opinions are often diluted in large organisations.
Currently we see three main themes that determine the medium-term economic outlook and our investment strategy. First, there is the dynamics of a post-bubble economy. Second, one of the forgotten main features of the bubble years has been a massive risk transfer in financial markets. Third, current risk aversion is not only cyclical but also has a structural component.
The dynamics of a post-bubble economy are very different from a normal balanced economy. Here the 1990-91 Gulf war serves as a fine example. At the end of 1991, the US economy was in a rather healthy post-recession situation. The US consumer had retrenched as from the crash of 1987, and there was an important amount of so-called pent-up demand along with a balanced current account.
As a consequence, the US economy could ‘auto-finance’ its economic recovery, as it did not depend on foreign capital to compensate for the lack of internal savings. But notwithstanding all these favourable elements, the Federal reserve cut rates 11 times for a total of 300bp (on the discount rate) after the war. In fact, three quarters of all interest rate stimulus was added in the post-war period, as the economy quickly relapsed after true initial end-of-war euphoria. This important ‘detail’ has been forgotten by most economists in their blue-print for the economy.
How can one seriously believe that no additional stimulus will be needed today, when 12 years ago a more intense post-war euphoria faded quickly and was not able to kick start a genuine economy recovery? Today, the US macroeconomic situation is worse, with major imbalances in consumer debt, twin deficits and corporate malfeasance. Therefore we believe that the economy will not recover as expected, and that in fact the US economy will grow below its potential in the coming years. We are even convinced that in due time, economists will adjust this “trend growth potential” down to its pre-bubble levels.
Risk transfer determines our strategy in bonds and equities. It relates to the sale of certain risks (especially credit risk), repackaged and often dispersed, to buyers who receive a premium. This transfer has been extremely important and has had an international dimension (US exporting its economic risk to other regions, especially Europe and Japan), and between sectors (banks have sold risks, which were ‘bought’ by insurers). The primary tools of this process have been credit derivatives and asset backed securities.
Risk transfer has been applauded by central banks as a way to disperse risk. But at the same time, risks have not decreased, they have just been transferred to sectors and agents who have less experience of managing these risks, in less regulated markets and with less visibility on the total amount of risk in the financial system. Buffett is right in warning against a time bomb. But this bomb might be slow to detonate and therefore spread its collateral damage over many years. In any case, this view has led us to underweight insurers within financials, and treat asset backed securities with care. Finally, we believe that the dollar will become an ultimate tool to transfer economic risk, as a steady depreciation is increasing deflationary pressures in Europe while doing the opposite in the US.
Risk aversion is often wrongly assessed. It has nothing to do with perceived high ex-ante risk premiums on equities. It relates to a situation in which investors are increasingly forced to pursue capital preservation instead of growth. Pension funds and European insurers are good examples. Although both perceive the equity markets as very attractive, they cannot increase equity positions because of their precarious asset-liability situation. They lack a ‘risk budget’ to accumulate fresh risks. Risk aversion has also a second dimension. Sometimes, financial markets do not remunerate investors for taking additional risks. Equity valuations in the US are only attractive on the assumption that the bubble years are soon to return. In a long-term perspective, US equities are not a convincing investment case. European stocks look all right, but with the risk transfer as a big negative for Europe, a double dip in the US or a further depreciation of the dollar will hit European equities hard.
In this framework, the war in Iraq has had only a very small ‘supporting role’. We think that the war will continue to play a role as an ‘excuse’ for revisions of economic growth and earnings in the coming months. Other events might start and take over this role: SARS, Syria, or another surprise. As noted above, sentiment only plays a minor role in our strategy. It influences of course our tactical asset allocation. All our models show that investors are quite bearish about US bonds especially and very bullish about equities. We are therefore tempted to continue to emphasise our bearish case on the US economy. Furthermore we have been playing on several more defensive and hybrid asset classes eg, dividend-yielding equities and high-yield bonds.
Geert Noels is chief economist and partner at Petercam Asset Management in Brussels