Has the fed
become the world's
central bank?

Luc Synaeghel, CIO 2016-04-07

During her recent speech at the Economic Club of New York, Federal Reserve (Fed) Chair Janet Yellen made a number of rather remarkable points – boiling down to a greater tolerance for inflation in deciding on the near-­‐term path for interest rates. She explicitly referred to economic activity in other regions of the world as a determinant of US monetary policy, effectively declaring the Fed the central bank of the world. Straying away from the usual central bank focus on domestic conditions, she also pointed to the potential impact of a rate hike on the currency, saying aloud what we have suspected for some time: the Fed is intent on avoiding a stronger greenback. Finally, she stressed the world’s need for stable (higher) commodity and oil prices, which of course go hand in hand with a more stable US dollar.
With the Fed having postponed its next rate hike, the Bank of Japan (BoJ) in wait-­‐and-­‐see mode and the European Central Bank (ECB) in even fuller action, the central bank grip on financial markets remains firm – regardless of how (badly?) this whole policy experiment will eventually end. Monetary easing in its different forms has not delivered the hoped-­‐for results in terms of real economic activity, largely because of a still broken banking system whose incentive to lend only diminishes as nominal rates are pushed down (more on page 2). Outside of the (late-­‐cycle) US, most of the inflation that has come from easy money has been confined to asset markets. The month of March thus saw equity markets do just what Yellen and Draghi wanted: rally significantly. As illustrated on page 3, the rebound was strongest in the US, with the S&P 500 index more than recouping its prior losses, fuelled by (valuation-­‐insensitive) speculative flows and corporate buybacks. We caution that this makes US equities vulnerable to another correction in a not-­‐too-­‐distant future, whether due to earnings reports that disappoint or to inflation data that forces the Fed to come back into the picture. For now, portfolio construction again entails a difficult choice between investing in zero (even negative) yielding bonds or equities that are broadly overvalued. The risk-­‐return trade-­‐off is far from appealing: investors are forced to take much risk in the hope of generating only meagre returns. We respond to this environment by allocating a lesser portion of portfolios to equities, but focussing that portion on the “riskier” segments. With an important proviso though: the risk that we take is business risk, which we believe will be rewarded by strong (and somewhat market-­‐ decorrelated) stock price performance as sector/company prospects improve, rather than valuation risk, which can only lead to stock price disappointment (details on page 4). We thus confirm our exposure to the still disliked and cheap oil, shipping and commodity sectors, as well as to Chinese equities. The path forward will not be smooth, but we continue to believe that their long-­‐run performance will prove very rewarding to patient investors prepared to weather the volatility.

CENTRAL BANKS: THE LIQUIDITY EXPERIMENT CONTINUES

In the US, price pressures are becoming increasingly visible at both the goods and wage levels, even though the inflation level varies substantially across cities/regions and upward wage trends concern mainly higher skilled workers. Annualizing first quarter data actually suggests that core inflation (excluding food and energy) is running at around 3%. Yet the Fed has chosen to defer its next rate hike, worried not only about financial market jitters (which were invoked last autumn for the delay in rate lift-­‐off) but now more generally – or at least more explicitly – about the global economic situation, commodity and oil prices, as well as potential US dollar appreciation. As already mentioned last month, we believe that the Fed has changed its game plan. Rather than raising rates by an incremental 25 basis points each quarter so as to ensure that prices pressures do not get out of control, it has decided to willingly run behind the inflation curve – leaving rates put for a period of time and then intending to hike them more aggressively down the road. The Fed’s greater short-­‐term tolerance for inflation was voiced just after the ECB unveiled yet more monetary measures, reminding investors that the world remains one of coordinated easy money. The positive results of this global liquidity experiment have yet to materialize at the real economy level. Proponents would probably argue that the US has reached a number of its targets, notably in the labour market, but did Fed policy really drive the country’s (subpar) economic recovery since the 2008-­‐2009 recession, or simply accommodate it? Ultimately, we continue to believe that politicians, not central bankers, hold the keys to economic growth, in the form of lower taxes or structural reforms. Central banks can merely buy them time to act. Meanwhile, showing up with greater clarity are the adverse consequences of zero/negative interest rate policies. Asset price inflation has of course been with us for some years already, as investors were gradually pushed up the risk curve, but bank lending is where the bite is currently being felt. Having been forced to delever their balance sheets in the aftermath of the financial crisis, so as to comply with stricter capital rules, banks now have to contend with nominal interest rates that stand close to the average default ratio on their loan portfolio. When, even with the strictest lending standards, the interest rate that can be charged on a loan does not cover the risk that is taken, a bank will require other guarantees – or not make the loan. And for a business owner, providing near 100% collateral in order to be granted a loan just makes no sense. As a result, lending to small-­‐ and medium-­‐sized enterprises is seriously lacking. What bank loans are being granted go mainly to larger companies – often to finance stock buybacks rather than investment in future growth. With its latest innovation, a program that subsidizes banks to make loans to businesses, the ECB has made clear that it is aware of the problem that it created in pushing interest rates down so far. Whether the measure will be sufficient to make a real change remains, however, to be seen.

VALUATION: US STOCK MARKET BACK TO HIGHS

Just when we thought that central bank influence on financial market was perhaps waning, monetary policymakers once again pulled their trick, successfully drawing financial markets out their early year doldrums. March saw a continuation of the rebound initiated mid-­‐February, with the US market clearly in the lead – and the only one to have recouped all of its prior losses.

Year‐to‐date performance of the main regional equity indices
(rebased at 100 on December 31, 2015)

Investment Letter 2016 April regional equity

Source: Bloomberg

The outperformance of US equities (S&P 500 index) is difficult to attribute to fundamentals. High valuation combined with receding earnings growth and profit margins cannot be deemed attractive. Rather, we believe that their strong rally was driven by momentum players, notably hedge funds awash with money (another negative side-­‐effect of quantitative easing), as well as the afore-­‐mentioned stock buyback programs.
Notwithstanding the ECB’s additional support, European equities (Euro Stoxx 50 index) remain in negative year-­‐to-­‐date territory. This is not surprising given the many issues currently on the old continent’s agenda: Greece, refugee crisis, Brexit, banking sector... We would also note that US investors have been pulling funds out of European markets, wary perhaps of being hurt again in 2016 by adverse currency trends. For our part, we continue to hold a position to the Euro Stoxx index, albeit with a somewhat “trading” approach.
In China, economic fears have abated with the National People’s Congress confirming the 6-­‐6.5% growth target and the reduction in banks’ required reserves. Make no mistake, an industrial recession is underway in China but it is being offset by a developing services sector. This gradual rebalancing of the Chinese economy may not be good for growth in the rest of the world, but the – very cheap – stock market should benefit, hence our recently raised exposure.

PORTFOLIO CONSTRUCTION: THE DIFFERENT FORMS OF RISKS

Speaking more generally of portfolio construction, the rebound has only served to make the task more challenging. With markets again at rich valuation levels, particularly in the US, future overall equity returns do not look bright. And bonds are of little help, with the government and investment grade segments offering minimal, indeed in many cases negative, yield. Investors thus again face a risk/return disequilibrium: much risk must be taken in the hope of generating only meagre returns.

To make matters worse, the correlation between asset prices is very high. Outside of (expensive) option protection and exposure to volatility (which we hold through a fund), it is difficult to find investments that will behave in an opposite manner to equity indices.

Our answer to this conundrum lies in underweighting equities but focussing our holdings on the “riskier” segments. We use that word carefully because it refers to a specific form of risk, namely business risk, which we far prefer to the valuation risk that currently afflicts much of the “blue chips” arena (witness Coca Cola trading at a price-­‐to-­‐earnings ratio of 27x, Adidas at 25x, L’Oréal at 25x, Unilever at 21x, AB Inbev at 26x, Danone at 26x, Nestlé at 24x, Novartis at 25x, Roche at 21x and Philips at 27x, just to name a few examples).

Business risk stems from difficult operating conditions but does not necessarily mean poor inherent quality. Indeed, we strive to find companies operating in challenged sectors but that have the financial and management strength to emerge as long-­‐term winners. Specifically, we have invested in oil and commodity producers, as well as bulk shippers. These sectors all currently suffer from excessive supply, making them hugely unpopular amongst investors – and hence very cheap.

Our initial forays into these sectors/companies were admittedly early, and have delivered middling performance to date, but we are convinced that their long-­‐run return will be extremely rewarding. The challenge will be to have patience and use the inevitable volatility episodes to gradually add to positions, not cut them back, as supply and demand move towards equilibrium and the companies’ prospects improve. Some of these investments, notably in gold mines, have already had a strong run recently, but we truly believe that the best is yet to come.