Tactical Positioning

Date: 05 Mar 2012


On 14th February, we pointed out that, with sentiment on an improving trend, we were pursuing a strategy of hunting out laggards. Japanese equities fall into this category prompting us to add at the end of January on a trading basis, taking the typical exposure in a client’s equity ‘bucket’ up from 10 per cent to around 15 per cent. As you will read below, this has been timely with Japan being one of the best performing equity markets in February. Other areas that we have looked at include large-cap gold mining companies and selected property equities. We are yet to make an investment decision on either of these areas, but we are constantly on the lookout for low risk ways of capturing upside.

In general terms, we remain slightly cynical about the overall ability of markets to break out into a sustainable bull phase. However, we do own a good mix of risk assets which is allowing us to capture some of the short term market upside without ‘betting the house’.

Market Moves

Equity markets continue to climb the proverbial ‘wall of worry’ as the negative sentiment of late 2011 is gradually dissipated by better economic data from the US, a softer-than-expected landing in China, falling inflation in emerging markets, and massive liquidity provided to European financial institutions by the European Central Bank’s Long Term Refinancing Operation (“LTRO”).

After the adrenaline burst at the start of the year, markets have continued to grind higher over the last fortnight to 24 February. Global equities have risen 2.4 per cent, with global emerging markets in line with this increase, and with Europe (+1.9 per cent), the UK (+1.8 per cent) and the US (also +1.8 per cent) just behind. The outstanding performer by a long way was Japan, whose equity market rose by 7.5 per cent over the fortnight (+3.5 per cent in US dollar terms), driven by easing measures from the Bank of Japan and the initiation of a formal inflation target (albeit only of 1 per cent!). The euro has continued to strengthen in line with risk assets, rising 1.9 per cent against the US dollar over the period.

Our old friend gold continues to add value to portfolios, and has now risen by 13.3 per cent this year. In an environment in which the central banks of all the world’s major reserve currencies are competing with each other to print more money and debase their currencies, in which real interest rates are very likely to remain negative for the foreseeable future, and in which there is clear secular demand growth from both emerging market central banks and the emerging consumer, we remain confident that gold has an important place in portfolios, despite its periodic volatility.

There have been some signs of increasing composure in fixed income markets. The US 10 year Treasury yield has risen from its extreme lows at the end of January, ending last week at 2.0 per cent. High yield spreads (yield on 10 year ‘B’ rated corporate bonds minus yield on 10 year US Treasuries) have narrowed during February from almost 6 per cent to just under 5.5 per cent today (benefitting our overweight positions in high yield bonds in portfolios). CDS spreads on the peripheral nations have narrowed, with Portugal’s most notably falling from a peak of 1,554 on 31 January to 1,107 currently, mirroring a fall in its 10 year bonds from 18.3 per cent to 12.8 per cent over the same period.

As the drivers among us have no doubt noticed (especially in the US, where the price of unleaded gasoline has risen by 13 per cent already this year), oil prices have been on a tear, with WTI Oil rising by approximately 10 per cent year to date and 45 per cent from its lows in October last year. The rise in the oil price has been propelled by fears over the delicate political situation in the Middle East, where Iran refused IAEA inspectors access to nuclear facilities where it is suspected it is developing nuclear weaponry, and Israel is threatening military action. Both the rising oil price (which hits consumers’ wallets and corporate margins), and the situation in Iran which is driving it, have the potential to derail the recent recovery in short order, and we will be monitoring these very closely over the coming months.

Economic Update

From a macro point of view, regular economic data continue on the whole to be quite positive (although as we argued a month ago, the ‘low hanging fruit’ here has been picked), while tail risks remain very much in evidence. In the US, employment data, consumer confidence, and manufacturing surveys have all improved, and surprised analysts on the upside. When we look at our weekly market monitor, the macroeconomic section is awash with positives. US leading indicators (from the OECD, the Conference Board, and the Economic Cycle Research Institute, or ECRI) are all pointing upwards. Credit spreads and the TED spread (which indicates stresses in the banking system) are moving in. Initial jobless claims are around their lowest level since early 2008. The rise in non-farm payrolls for January at 243,000 was almost double consensus expectations. Consumer confidence continues to improve, and in fact there was a massive rise in the Conference Board survey on Tuesday.

That is not to say that everything is rosy. Durable goods orders dropped in January by 4.0 per cent, far greater than a projected fall of 1.0 per cent. US house prices are showing weakness again (in what some commentators have termed a ‘triple dip’). But on balance the data we are seeing are consistent with a slow recovery in the US economy, and are far more encouraging than were seen in the depths of Q3 2011. (We note, however, as every good student of value investing knows, that as John Bennett of Henderson recently put it: “you need bad macro to get good bargains” in the stock market!)

Outside the US, the economic picture is weak but also seems to be stable – perhaps surprisingly so in the case of the Eurozone, where preliminary PMI survey results (a survey of corporate purchasing managers on various factors relating to their businesses, and typically a good leading indicator of economic activity) remain around neutral. The Chinese PMI is in a similar position, although note that this suggests limited downside to the current c. 8 per cent GDP growth trend, for now.

What of the Eurozone? This remains both a tail risk and a headwind for markets. The tail risk is default. If Greece defaults, and leaves the Eurozone – which is far from unthinkable, especially given German mutterings in this direction – markets could become very rattled indeed. What of CDS (credit default swap) protection which the banks have sold, and would have to pay out on in the event of a default? No one really knows which banks would be most exposed to a Greek ‘credit event’ given that many CDS contracts were traded off-exchange, and this is a source of concern in itself.

The headwind is simply politics. As the Prime Minister Jean-Claude Juncker of Luxembourg aptly put it in December last year: “We all know what to do, but we don’t know how to get re-elected once we have done it.” Politicians are torn between necessary reforms and the wishes of the electorate which they represent. Yesterday morning the Irish caused consternation in Europe by announcing that they will stage a referendum on the fiscal treaty which was agreed among 24 EU states several weeks ago. And already we are seeing signs that the latest Greek deal may be a hopeless compromise. According to IMF data, Greek debt only returns to (possibly) manageable levels of 129 per cent in 2020 if the Greek economy breaks even next year and returns to 2.3 per cent growth in 2014. We wouldn’t bet on it! Under the IMF’s downside scenario (whereby Greek GDP falls by 1.0 per cent next year and then returns to growth (but of less than 2.3 per cent) in 2014, debt to GDP will still be at 160 per cent by 2020, and Greece would require a further ‚Ǩ245 billion in bailout funds. The sensitivity of these forecasts to even small disappointments in growth is staggering. These and other uncertainties inherent in the complex melting pot of European politics virtually guarantee a continuation of the market schizophrenia we have experienced in the last two years.

We continue, therefore, to feel at the moment that it is both dangerous to be too bearish given improving macro and attractive valuations in many areas, and also dangerous to be too bullish given the tail risks which abound, both in Europe and between Israel and Iran in the Middle East. We are talking our own book, but then our book would not be positioned as it is if we didn’t believe (and invest our own money) in it! The great commentator Marc Faber observed at the start of January: “I think that most investors lack patience and simply cannot accept the fact that there are times when trading little and holding a diversified portfolio of different assets … may be the best strategy”. We agree that this is such a time, and that investors such as ourselves with the patience and the ability to ‘sit tight’ in a robust, well-diversified portfolio will be rewarded for our perseverance.

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