Quarterly Report

Management report - 1st QUARTER 2016 Q1 2016

by
19.04.2016

Macroeconomic analysis

Joint action by the major central banks and the Chinese government has improved sentiment and allowed risk assets to rally, especially in the two powerhouses of global growth: the United States and China. Although the economic environment has undergone a few changes since our previous analysis, we continue to believe that the current equilibrium signals an ever weakening global economy. This disappointment on the growth front will probably confirm the failure of innovative monetary policies pursued since March 2009 and require a fiscal policy response.

Global perspective

In our previous report, we expressed a cautious view of the equity market based on our scenario of disappointing economic growth in the United States where monetary normalisation is under way, a weaker Chinese yuan threatening global liquidity and - alongside the drop in other emerging market currencies - compounding underlying deflationary pressures already made worse by the oil crash: "The monetary policy reversal in the US was the novel factor that dominated the last quarter. This change in policy will keep risk assets under pressure by threatening to turn our projected US economic slowdown into a recession, amid deflationary pressure and a liquidity dry-up." Apart from our very cautious positioning on the equity market, this diagnosis led us to "expect the dollar to remain weak as the Fed appears increasingly less threatening in the short term".

The US Federal Reserve soon confirmed our analysis by becoming less of a concern, contributing to the depreciation of the dollar. However, China combined its fiscal and monetary firepower with partial control of its foreign exchange market to limit capital outflows. For its part, the ECB pulled out the big guns to combat deflationary pressures weighing on the Eurozone. The combination of these decisions may have given the markets the impression of concerted action, which improved sentiment and allowed risk assets to rally, especially in the two powerhouses of global growth: the United States and China. Both are benefiting from the delay in raising US interest rates. The former through the belief that growth will be more sustainable and the dollar more competitive; the latter - along with the emerging world as a whole - through better liquidity conditions. This is possible because a devaluation of the yuan has temporarily become less necessary: US monetary policy is more accommodative than expected, the dollar has fallen and, for oil producers, crude prices have risen.

Should this improvement change the macroeconomic views that we have held since August 2015? We really don't think so. Central bank intervention is clearly showing its limits in Europe and Japan - countries that are suffering from strengthening currencies relative to the dollar, despite their negative interest rates. Furthermore, the question of US economic resilience without additional stimulation will be raised once again if the economy slows, as we continue to expect.

United States

US economic growth is slowing. Economists are starting to agree with our early 2016 scenario of growth remaining under 2%. The healthy leading macroeconomic indicators released at the beginning of this quarter should not distract from the wider picture. They largely result from the improvement in general sentiment brought about by the latest decisions on monetary policy, even though its growing inefficiency is becoming increasingly clear.

There are three main reasons for our reservations about US growth. First of all, we see that leading investment indicators are steadily deteriorating. For example, profit margin growth calculated at a national level came in at -2.7% y/y in 2015, the lowest it has been since the beginning of 2008. Growth in new orders for durable goods was zero, while the production capacity utilisation rate, which has been falling constantly since July 2014, dropped from 78.9% to 75.4%. In the circumstances, it is hard to be upbeat about investment, which has never managed to find any real impetus since recovering from the Lehman shock.

Consumer spending has also been disappointing if we take into account the substantial rise in purchasing power that has arisen from the oil crash. Consumer spending growth has stayed close to the 2% mark for the last six months and has been a major supporting factor for US GDP growth. The stabilisation of oil prices could weaken this unique growth driver.

The sluggish labour market is a reflection of lacklustre consumer spending. The unemployment rate may have fallen to 4.9% of the working population but this figure is artificially reduced by the participation rate remaining close to its all-time lows and by the high number of part-time jobs being created (one person working three part-time jobs would still show up as three jobs in the statistics). Very low hourly wage growth (2.3% per annum) also reflects the real availability of US labour.

Finally, the cyclical upswing in inflation, fed by stabilising oil prices, a weaker dollar, the rise in rents (heightened by the difficulties for first-time buyers) and the higher price of non-discretionary goods and services will make the stabilisation task very difficult for the Fed if it has to revert to a policy of monetary easing. This inflation, which other than rents has little to do with firmer demand, has not coincided with wage growth and consequently, may end up weighing on household purchasing power. A spot of stagflation cannot be ruled out. However, after ending its quantitative easing in September 2014, the Fed still has some leeway judging by long-term interest rates (1.70% compared with 0.09% in Germany and -0.06 in Japan), which gives the United States an unarguable defensive status.

management-report-q1-2016-63-MC-1.jpeg

Emerging countries

The emerging world is benefiting the most from the main central banks' joint intervention. The weakness of the dollar reduces downward pressure on the yuan and, indirectly, on the currencies of many emerging market countries. This appreciation improves liquidity conditions, which benefits the markets and boosts economic sentiment, especially as the dollar's fall coincides - as it should - with a commodity rally, led by oil, to the advantage of producer countries' accounts.

Once again, it was China with its dual monetary and fiscal stimulus that, by helping itself, ended up helping the emerging world and beyond. But what is the final outcome? We think that using the budget deficit to revive investment is not what China needs at this stage of its development, and that using these "tried and tested methods" will merely buy time before the inevitable economic and monetary adjustment that the authorities have been trying to avoid. Overcapacity resulting from the 2008-2009 stimulus package has not yet been reabsorbed. World trade opportunities also remain limited; the major emerging market exporters are still having just as much trouble increasing their foreign sales, although higher commodity prices could lead to a recovery in the months ahead, as suggested by the first signs of an improvement in exports, which appeared very recently in South Korea (+4.9% y/y). Signs emanating from the emerging world are brighter, with the Markit PMI climbing back above the symbolic 50 mark in April.

The financial situation of emerging countries has undeniably improved in recent months, and is weighing less heavily on global liquidity than we might have feared not long ago. The depreciation of the dollar has played a role in this.

management-report-q1-2016-63-MC-2.jpeg

Europe and Japan

Recent developments in Europe and Japan are quite different in nature and confirm our deflation views to an even greater extent than we imagined, revealing the limitations of central bank intervention. Key interest rates and a fair portion of the government bond yield curve are in negative territory.

Yet the euro and yen are appreciating, heightening deflationary pressures, making export-driven growth all the more difficult and possibly impacting growth itself: very low interest rates with no prospect of recovery encourage financial engineering and property buying, but fail to drive productive investment. What can such low interest rates mean to an entrepreneur if not the expectation of sluggish growth, making investment hard to justify? In Japan, the Tankan business climate index weakened considerably over the first quarter, while in Europe the outlook component of the most closely followed leading indicators of manufacturing activity, the IFO, slid towards three-year lows.

European consumer confidence reached a 27-month low in March. These trends impacting exchange and interest rates as well as macroeconomic activity reflect the strength of deflationary pressures at work and the European and Japanese central banks' inability to counter them. They also raise the question of how much leeway remains.

Although the economic environment has undergone a few changes since our previous analysis, we continue to believe that the current equilibrium signals an ever weakening global economy. In Europe and Japan, negative interest rates are no longer having any effect on deflationary pressures. In the emerging world, the weaker dollar and the prospect of a return to accommodative policy in the US are improving liquidity and sentiment, but are doing nothing to solve China's structural problems. And in the United States, the momentum of the economic cycle seems feeble at best. Disappointment on the growth front will probably confirm the failure of innovative monetary policies pursued since March 2009 and require a fiscal policy response. China is already leading the way. The political agenda - Brexit referendum, US and then French and German elections - and the European stability pact now render these big fiscal decisions largely hypothetical, while making the current fragile balance even more precarious. A new crisis alone seems capable of making them possible.

management-report-q1-2016-63-MC-3.jpeg

Although the economic environment has undergone a few changes since our previous analysis, we continue to believe that the current equilibrium signals an ever weakening global economy. In Europe and Japan, negative interest rates are no longer having any effect on deflationary pressures. In the emerging world, the weaker dollar and the prospect of a return to accommodative policy in the US are improving liquidity and sentiment, but are doing nothing to solve China’s structural problems. And in the United States, the momentum of the economic cycle seems feeble at best. Disappointment on the growth front will probably confirm the failure of innovative monetary policies pursued since March 2009 and require a fiscal policy response. China is already leading the way. The political agenda – Brexit referendum, US and then French and German elections – and the European stability pact now render these big fiscal decisions largely hypothetical, while making the current fragile balance even more precarious. A new crisis alone seems capable of making them possible.

Investment strategy

Our positioning reflects these concerns.

The equity market exposure of our global funds remains close to its minimum levels. This decision has been upheld since August, with the exception of occasional re-indexing. Our hedging strategy focuses on European and Japanese markets, which are most vulnerable to deflationary pressures and to the doubts cast over central bank intervention as we know it today. The US market has shown resilience for several months now. Less cyclical than others, it also benefits from wider room for manoeuvre in monetary policy and is supported by a number of companies able to prosper in the deflationary environment that we have described. Our major Internet holdings exhibit this fundamental quality. After underperforming for five years, some emerging countries could win us back over, as US monetary normalisation remains a distant prospect and Chinese growth continues to receive support. Overall, our managers focus on investments with good visibility, low dependency on the economic cycle, and an ability perform in a deflationary environment.

On fixed income markets, US government bonds alone seem to hold sufficient value. The economic slowdown expected in the United States should confirm this. Our corporate bond approach remains very targeted and opportunistic; we are quick to hedge global risk after periods of sharp spread narrowing.

The foreign exchange market presents some interesting short-term opportunities in the emerging world, which is benefiting from the dollar’s spot of weakness. The yen remains the currency to benefit the most from risk aversion and, as such, retains a considerable place in our allocation. We have reduced our exposure to the dollar as we await a market shock, from which it would surely benefit. The market may yet have to take into account the delay or even the halt in US monetary normalisation.

Overall, our very limited net exposure to equity markets will not prevent us from capturing value wherever it may be found: defensive stocks, gold mining, energy, quality corporate bonds, the yen, some emerging market currencies and, soon, the dollar.