Physics has the elusive Theory of Everything which consists of several Grand Unified Theories and which represents the holy grail of the science and which "fully explains and links together all known physical phenomena, and predicts the outcome of any experiment that could be carried out in principle." In other words, once proven it would make life boring. We doubt it ever will be. Finance does not have anything like it, for the simple reason that while physics is a deterministic science, finance, predicated to a big extent on assumptions borrowed from the shaman cult known as 'economics' is always and everywhere open ended, and depends just as much on chaotic 'strange attractors' as it does on simple linear relationships. Yet when it comes to presentations, especially of the variety that attempt to explain not only where we are in the world, and how we got there, but also where we are headed, we have yet to see anything as comprehensive as the Investment Strategy guidebook from Pictet's Christophe Donay. If there is indeed a holy grail of presentations, this is it, at least for a few more instants, until something dramatically changes and the whole thing becomes an anachronism. In the meantime learn everything there is to know about global decoupling and the lack thereof, the reality of an over-indebted global regime and its 3 incompatible targets, the outlook for the US and the 30% probability of a hard recession, a recessionary Europe and the five possible outcomes of its crisis, China and its hard landing, and how this all ties into an outlook on where the world is headed together with appropriate investment strategies and proper asset allocation, the fair value of the EURUSD, systemic risk evaluation, cross asset correlation, the impact of central bank intervention, debt redemption profiles, the role of gold and commodities in the new reality, and virtually everything else of importance right here and right now.
From Pictet Investment Strategy 2012:
1. Global overview: current major trends in the global economy
- Developed markets’ growth cycle is not virtuous due to the lack of credit and job creation. Growth rates are well below their potential. At the opposite, emerging market economies benefit from vigorous domestic demand: economic growth does not show any sign of serious
- Inflationary pressures should recede by the end of this year in both developed markets and emerging markets’ economies. Headline figures evolve well above levels targeted by central banks.
- In 2011, developed markets’ central banks adopted new rounds of quantitative easing except the ECB. However, the efficiency of monetary intervention is limited because credit mechanisms are still broken: the deleveraging process is still ongoing.
- The euro crisis is intensifying. Governments struggle to adopt adequate measures to tackle the source of the problem.
- As a consequence, financial markets are requiring higher risk premiums for sovereign bonds. It generates aggravating financing conditions in the real European economies. Hence economic growth is on the path of a vicious circle.
2. US: instability in growth as a consequence of the end of the Great Moderation
3. Double global decoupling in DM’s versus EM’s
4. Central and alternative scenarios for DM economies
5. From 2008, DM economies have entered an over-indebtedness regime
6. In an over-indebtedness regime, DM governments have 3 incompatible targets
7. The five possible outcomes of the euro crisis
8. Global Trends
- The end of the Great Moderation could increase States’ controls. Central banks, under the pressure of governments, will be more and more tempted to embrace new rounds of currency exchange rates and capital controls.
- The lack of public financial resources implies that governments will impose new regulations to trap capital in domestic markets.
- The final outcome of the euro crisis remains uncertain: we don’t expect a collapse of the eurozone. But the two ultimate resolutions depend only on political decisions: fiscal union and/or the ECB monetizing governments’ debts. Because Europe is multi-cultural, the decision making process is long and painful.
The United States
9. US: the effective GDP level remains well below potential
- And if our growth forecasts prove correct, the negative output gap will actually widen in 2012
10. US: the employment cycle persistently diverges from the investment cycle
11. US: growth in nominal labour income decelerated sharply in H1…
- …but seemed to have bounced back somewhat over the past few months
12. US: existing home sales have disappointed over the past few months
- Housing starts remain globally very weak, but the multi-family segment is recovering strongly
13. US: budgetary policy should be restrictive in 2012,…
- …but to what extent will depend heavily on what is decided in Congress over the coming weeks
14. US: central scenario - Growth recession in H1 2012
- As expected, growth bounced back in Q3 relative to H1, and prospects for Q4 appear modestly upbeat as well.
- However, this improvement is mainly linked to the unwinding of transitory drags, namely the oil and Japanese earthquake shocks.
- The ongoing recovery remains fairly weak, the housing market depressed and, unfortunately, the debt ceiling drama, the US downgrade and the intensification of the European crisis have led to a sharp confidence and financial shock that will continue to weigh on growth over the coming months.
- Moreover, budgetary policy will likely become more restrictive next year, to an extent that will depend on political decisions taken before year-end.
- In that context, we expect the US economy to experience a growth recession in H1 2012, i.e. not a full-blown recession, but still with GDP increases that are insufficient to prevent a rise in the unemployment rate, followed by some modest improvement in H2.
15. US: alternative scenario - Risks of a full-blown recession
- Our central scenario implies a 2012 growth rate well below consensus estimates. But that’s not the end of the story. We see downward risks as quite sizable. Two elements are particularly worrying:
- Fiscal policy: we believe measures to limit the fiscal tightening in 2012 will be taken before yearend. However, full political paralysis is possible, which would lead to a sharp tightening in 2012.
- European crisis: encouraging developments on that front were short-lived. A further deepening of the European crisis may well happen now, or at some stage or other next year. This would have a further substantial negative knock-on impact on the US.
- If one of these two risks becomes reality – or at worst both, a full blown recession is likely in the US next year. This is our alternative scenario and, unfortunately, we give it unusually high probabilities (around 30%).
- However, we believe that if there is a recession in the US, it is likely to remain relatively mild.
16. Euro area: even the Germans households have capitulated - Consumer confidence suffered a hard knock over the summer
17. Euro area: surveys now clearly in recession territory - Only the post-Lehman deterioration was as rapid as the current downswing
18. Euro area: PMI surveys heralding a recession for the coming winter
19. Euro area: conclusion and key takeaway for 2012: Things are likely to get worse before authorities adopt definitive measures
- Changes in governments of the periphery (Greece, Italy, Spain) could offer some temporary relief as adjustment programmes will be easier to implement.
- But the benefits of adjustment programmes are likely to disappoint again as recession will probably hit during the winter.
- Consequently, the confidence crisis related to imbalances between the huge financial needs and the responses in terms of aid packages will continue to loom large.
- At this point, pressure will mount on the ECB to significantly step up intervention. This action will offer the needed relief to give authorities the time to mould a new shape for the monetary union
- institutionalize a form of fiscal transfers
- European Monetary Funds, fiscal union or euro-bonds…
- new Treaty
- institutionalize a form of fiscal transfers
- The euro should survive, but things are going to get worse before European authorities decide to wheel out their heavy artillery
20. China: 2011, the monetary tightening process is over - Curbing loan growth was about containing indebtedness ratios and reducing leverage within economy
21. China: hot money inflows have not facilitated the tightening process - High economic growth, interest rate hikes and Yuan appreciation attracted too much capital
22. China: inflation topped in July with the last interest rate hike - The decline in inflation doesn’t mean inflation will not remain structurally higher than in the past
23. China’s urban households leverage: a rise in consumer debt? - Household debt to disposable income rose only from 26% in 2005 to 45% in 2010
24. China: investments are normalizing to ensure sustained growth - Growth should remain investment-led in 2012 but a bit less than during usual pre-crisis paces (25% yoy)
25. China: growth is structurally declining for next years - Higher inflation is the new normal for China for the next several years.
26. China: conclusion and key takeaway for 2012 -Growth will continue to decelerate to a new lower potential, on the background of a structurally higher inflation.
- Policymaking in 2012 is about stabilizing growth at potential (8.5-9.0%) and bringing inflation below 5% (4.5-5.5%).
- It is about reducing reliance on credit, allowing a better allocation of capital, contain irrational and excessive infrastructure spending to ensure quality of growth (impeding waste in capital).
- Use of fiscal spending should be expected in public works to support growth and cushion deceleration of growth during restructuration phase:
- Social housing
- Water conservancy
- Subways and urbanization
- We expect promotion of capital expenditures in manufacturing sectors for upgrading the economy and climbing the value chain.
- Enhancing social safety net to contain inequalities & promote consumption (wealth accumulation) is called inclusive growth.
- Local government debt, shadow banking, bad loans, property developers, etc… will still be a overhang on sentiment. But if these problems are a serious concern, they are not insurmountable and do not threaten China’s economy.
Global economic overview takeaway
27. Global economic overview takeaway (I)
- Our economic growth forecasts for 2012 for developed markets have fallen significantly over the past few months. While it is not our core scenario, the likelihood of a global recession (double-dip) is increasing.
- The global economy is still characterized by a double decoupling and lower economic growth at 3.5%.
- First decoupling: emerging versus developed economies.
- The United States and Europe face a lack of domestic demand. Private consumption is impaired by too few job creations. The public debt deleveraging reduces government spending.
- With 0.5% GDP growth in 2012, Europe is close to a recession, while growth in the United States at 1.5% is well below its 3% potential.
- Emerging markets are running at an average of 4% sustainable growth rate.
- In case of a significant economic slowdown, low public debt-to-GDP ratios in emerging markets will allow governments to envisage a strong fiscal policy. The over-indebtedness regime in which developed markets are deeply stuck greatly limits their leeway to act. Only a new style of fiscal policy could become a game changer (e.g. new supply side economics after the next US presidential election).
28. Global economic overview takeaway (II)
- Second decoupling: coexistence of two inflationary regimes:
- In developed markets, headline inflation in 2012 is expected to converge quickly to the core inflation rate. Central banks in these markets should start to adapt their monetary policy style from inflation targeting to nominal GDP targeting.
- In emerging markets, headline inflation should stay well above central banks’ targets.
- In spite of the fact that inflation will diffuse in the economies, the PBoC has already reassessed its inflation target upwards to 4%.
29. Record Asset Correlation
30. Nominal returns of asset classes depend on risk / reward ratios
31. Asset allocation in risk-off / risk-on modes
32. Currencies: strong nominal GDP growth is a handicap for currencies!
33. Inflation is crucial for currency performance
34. Currencies’ performance dispersions segregated in 3 volatility regimes
35. Currencies: risk-on and risk-off modes of the main currencies
36. Currencies: EUR/USD short term determinants - Pressure on the euro suggests it should be at EUR/USD 1.30 currently
37. Currencies strategies depend on volatility regimes
38. Central banks’ intervention in currency market
39. Currencies: asset allocation framework for currencies
- The CHF safe-haven behaviour is artificially blocked. As a result, the CHF will move in line with the EUR versus other currencies.
- The CHF should remain in the narrow range of EUR/CHF 1.20-1.25 in coming months. The SNB policy is credible in our view and an attack of the CHF is unlikely anytime soon.
- In the course of 2012, the Swiss franc could weaken further either because of another SNB intervention or because of the deterioration in the Swiss economic cycle (mostly deflation).
- The GBP should remain range-bound in the coming year between EUR/GBP 0.85-0.90 and GBP/USD 1.55-1.65.
- This apparent stability finds its origin in the unique policy mix adopted by the UK: quantitative easing and fiscal tightening. While awkward at first sight, this policy mix balances well short term risk (growth) and long term credibility (public finance).
- The JPY upward trend is likely to continue throughout 2012 (USD/JPY 70 year-end).
- Globally low yields refrain Japanese investors to recycle their current account surplus abroad.
- In spite of the strong appreciation of the JPY, it is not massively overvalued, as it is the case for the CHF. Consequently, Bank of Japan interventions are unlikely to reverse the upward trend, while adding some volatility.
- The ECB easing cycle should weigh on the EUR in coming months. The eurozone debt crisis remains a key risk. The USD should benefit from the EUR weakening, until the possible launch of a QE3 in the US.
40. Equities: since 2000, we are in a secular equity bear market
- In the financial literature, there is no formal definition of a secular bear market.
- We propose the following definition, built around four parameters:
- Intensity, combining an amplitude of the decrease of more than 30% over a minimum period of 3 to 5 years;
- Volatility: a long term down-trending market is accompanied by a sensible and persistent increase in market prices’ volatilities;
- An economic growth that is not self-sustained while the secular bear market develops;
- A massive deleveraging process of economic agents, who abusively used financial leverage during economic growth phases.
- Intensity, combining an amplitude of the decrease of more than 30% over a minimum period of 3 to 5 years;
- A secular bear market is always interrupted with sharp rebounds: secular bear market rallies.
41. Equities: since 2000, we are in a secular equity bear market
- The last shock of innovation of the TMTs lasted six years, from 1995 to 2000. It caused an increase of 233% in the S&P 500 and an average annual growth in real GDP of 4%, i.e. 100 basis points above the previous annual average (since 1950).
- Since 2000, without any innovation shock, the average annual growth of U.S. real GDP was only 1.5%.
- Over some 11 years, the S&P 500 has declined by 24%, reaching even 56% at the low of March 2009.
- Over the period, the average volatility was 22% compared to 14% during expansionary phases.
- During these 11 years, the U.S. economy experienced three phases of deleveraging. Firms deleveraged between 2000 and 2004. Since 2008, households are doing so. Recently and for some years to come, governments are deleveraging as well.
- Between 2003 and 2007, the decline in S&P 500 was broken by a cyclical bear market rally of 96%, accompanied by an average annual GDP growth of 2.9%. Also, between March 9, 2009 and April 29, 2011, the S&P 500 rallied by 101.6% and average real annual GDP grew by 2.6%.
42. Equities: volatility has a major impact on equity returns
As risk increases:
- Extreme performance becomes more likely (kurtosis).
- Extreme negative performance is more likely than positive (skewness)
Q4 11 - Q1 12 are expected to remain in high volatility regime.
Macro and political decisions would trigger volatility regime switches in 2012
43. Equities: valuation ratios by volatility level
- The higher the volatility, the wider the range.
- In the high volatility regime, our best educated guess should lie between 7 and 12, capturing 73% of possible past outcomes.
- A volatility decrease would trigger an increase in valuation ratio.
44. Equities: long term Price-to-book (Europe and US) - Pre-1987 crash period and 2000 bubble distorted valuation regime.
45. Equities: euro area banks and CDS spreads
Government and Corporate Bonds
46. QE1, QE2 and Twist are pushing long-term rates downward
47. Redemption for public debt by end-2012 amounts to a total of €1’049 bn !
48. Bonds: 10-year bond yields fell heavily in Q3, to about 2.1% currently
- However, due to a relatively high core inflation rate, our model is still pointing to a figure of 3.7%...
49. VIX Leading
Commodities and Gold
50. Commodity price volatility rises with risk aversion - Commodities’ beta is a function of risk aversion
51. Commodity returns are negative when risk aversion is very high - Negative relation appears only above a certain risk aversion level (above 1 standard deviation)
52. Returns are asymmetrically distributed - Extreme volatility tends to be associated to negative returns
53. Commodity prices depend on industrial activity - When industrial activity falls, commodity returns remain positive as long as inflation is high
54. Commodities’ performance depend on the world’s real activity - When activity falls, commodity returns remain positive as long as inflation is high
55. Existence of two return regimes for commodities - Depending on extreme inflation behaviour (high & rising inflation vs. low & falling inflation)
56. 2012 : recovery year for commodities
2012 commodities scenario - Paradigm remains intact
- Commodities scenario depends on 3 key points:
- Inflation: on a downward trend
- Growth: down in H1, recovery in H2
- USD: stronger until Q1, weaker in H2
- Impact on prices:
- Commodity price trends to recover in 2012
- Volatility to be highest in Q1/Q2 and to moderate thereafter
- Inflexion point end of Q1 2012, beginning of Q2 2012 : possibilities to enter the
- Commodities market to play momentum
Impact on inflation
- Price swings in 2012 will continue to be important but:
- General upward trend not steep enough to be inflationary
- Downside corrections not durable enough to be disinflationary
- Commodities not a source of inflation or disinflation in H1 2012.
- Recessions in both Europe and the US, Chinese exports are severely hit
- Commodities decline to 2008 crisis comparable levels, volatility hits extremes, should however provide excellent entry points, as in 2008.
Wrap-up and conclusions
57. Investment strategy takeaway (I)
Because the doubt about the sustainability of the global economic recovery and the final outcome of the euro crisis remain the two main drivers, the 2012 investment outlook should be amazingly similar to 2011.
Financial markets should be driven by political decisions. In developed markets’ economies, economic policy will be required to boost economic growth, but governments lack leeway to act due to deep public deficits and painful overindebtedness.
Receding inflationary pressures should allow developed markets’ central banks to act in favour of growth. But will they do it ?
We have determined 3 volatility regimes for most asset classes: equities, currencies and commodities.
The low volatility regime is observed in a standard economic growth cycle. It does not apply to economies of developed markets ever since they evolve in a overindebtedness regime.
In 2012, financial markets should continue to evolve in volatility regimes ranging from average to high, in function of the systemic risk aggravation (euro crisis and bank bankruptcies).
In these volatility regimes, the correlation between asset classes should stay abnormally high in 2012.
58. Investment strategy takeaway (II)
In such an environment, our tactical asset allocation style remains appropriate. We articulate the asset allocation and the portfolio construction in two stages. The first aims at protecting capital and at generating a return from defensive assets: gold, corporate bonds and low volatility equities.
The second aims at generating a return through the tactical asset allocation.
The frequent sudden and brutal tendency disruptions should constitute the investor’s environment.
The major market tendencies to construct the TAA should be:
- A continuation of the equity secular bear market. The economic slowdown is pressuring earnings growth, which is the main driver of equities.
- Developed markets’ sovereign bonds are classified in two groups. The first, safe government bonds, is represented by German Bunds and US Treasuries. The second includes government bonds that remain at risk.
- The aggravation of the over-indebtedness of states crisis could affect the safe haven status of the German Bunds and US Treasuries.
Performance discrepancies between currencies could increase in an elevated global market volatility regime. However, unilateral central bank currency market interventions create dysfunctions. As a consequence, playing these markets will prove difficult.
Even though gold has become more volatile, the asset maintains its safe haven status. The unavoidable developed markets’ central bank interventions constitute the fundamental driver for the increase in gold price towards our medium term price target of USD 3’000.
Corporate bonds, particularly in the investment grade segment, are of real interest for investors. Corporate bonds remain a strategic asset.