Tactical positioning

Date: 17 May 2012


Following the recent setback in equity markets it is worth emphasising that we have remained below target in risk assets throughout the first few months of 2012 given the tail risks which were lurking in the background. At the time of writing, this seems to be (and to have been) the right stance to take, but we remain vigilant for opportunities to add risk selectively at depressed levels, if these should arise – European equity valuations in particular may already discount the negative outlook and for long term investors look to me as though they offer good value even if a Greek exit from the euro leads to more turmoil. For both of these reasons we are not reacting to the recent fall in equity prices by reducing our holdings.

After a period of range trading following the impressive rally from late 2011, markets now appear to have reversed direction and broken through the bottom of their holding patterns. Worries about Europe have been foremost in investors’ minds although we may be reaching the point at which these worries are already priced in. Indeed, in local currency terms, European equities were the best performing of all the major regional equity markets that we track in this Bulletin! Even European banks fell just 3.3 per cent (cf. the S&P 500 -3.4 per cent) despite the possibility that a Greek exit will gouge further holes in their balance sheets and force them to bring out the begging bowls once again. Elsewhere, emerging markets fell by 3.1 per cent, the UK market by 3.5 per cent, and Japan by 5.8 per cent (only slightly mitigated in US dollar terms, this time). The euro weakened by 2.5 per cent, having previously held up well against the deterioration in the political and economic backdrop, while US 10 year bond yields tightened to 1.78 per cent at the time of writing (approaching post-war lows set last September). The German 10 year bund is now yielding below 1.5 per cent, and the Swiss 10 year bond less than 0.6 per cent!

Regular readers may be wondering how the switch of our remaining non-gold commodities positions into the US Financials ETF (“the XLF‚Äù) has gone, given the recent travails of that sector both in Europe and selectively in the US. The first response is to emphasize that we have studiously avoided exposure to European Financials, both in our equity and our fixed income exposure. As shown in the chart below, by the fourth quarter of last year the fourteen largest European banks had written off 3.7 per cent of loan assets since the financial crisis, compared with 7.8 per cent in the US. US banks have not only taken over twice the write-downs, but are also years ahead of European banks in terms of equity issuance, with robust capitalisations and in the words of Warren Buffett at his latest Berkshire Hathaway shareholder meeting, “liquidity coming out of their ears‚Äù.

Since we made the switch both have fallen. The XLF ETF is down 7.0 per cent, while the commodities fund which we exited is down 7.4 per cent. The very slight relative outperformance is no consolation at all when one is losing money in absolute terms. The debacle at JP Morgan’s trading desk did not help, with that bank (which represents 7.9 per cent of the ETF) down 19.4 per cent over the same period, accounting therefore for 1.5 percentage points of the ETF’s fall. We are not so na√Øve however as to expect our satellite (and more directional) positions to pay off immediately, and are conscious that evaluating this move over little more than a month is an unrealistically short timeframe. We remain convinced of the fundamental investment case, and that with patience the value embedded within the US Financials sector will be recognised by the markets.

The situation in Europe has deteriorated significantly over the last couple of weeks, with a Greek exit from the euro increasingly likely (although by no means a certainty as some more bombastic commentators would have us believe). According to a poll late last week, popular support for Syriza, the left-wing party standing on an anti-austerity ticket, has risen sharply to 25 per cent from the 17 per cent they polled in the election the previous weekend. This is far above the 19 per cent with which the New Democracy party came first in the election, and while it would not secure a majority of 151 for Syriza, it would (according to Greek journalist Efthimia Efthimiou, via the Guardian newspaper) make them by far the largest party in the parliament, with 128 seats (including the 50 seat bonus for coming first) compared with New Democracy which would have just 57 seats.

We have tried to approach the Greek euro exit question from three angles: what would it mean for Greece, what would it mean for Greece’s creditors, and what would it mean for the remainder of the Eurozone peripherals? For Greece, it would initially mean turmoil ‚Äì bank failures, collapse in foreign investment and massive loss of international purchasing power. However, as Roger Bootle of Capital Economics rather provocatively suggests in an article published last Sunday: “The big danger for the rest of the Eurozone is not that Greece makes a complete horlicks of monetary independence, but rather that it makes a comparative success of it. For this to happen, life in the proximity of Syntagma Square does not have to become a cakewalk; it just needs to be better than the current situation of economic collapse without prospect of relief‚Äù. In other words, with the flexibility of its own exchange rate, Greece might ‘do an Iceland’ and make the necessary adjustments with foreign creditors taking the bulk of the strain rather than its long-suffering populace. Angela Merkel has made it clear that the fiscal pact is not up for negotiation. If Greece rejects austerity it will not receive funding and will have to leave the Eurozone. At some point Greece is going to have to overcome the cognitive dissonance between almost three quarters of the population voting for anti-austerity political parties at the election (and probably more now), and over three quarters (by the latest polling) wishing to remain in the Eurozone.

What would a Greek exit mean for Greece’s creditors? Nikolaos Panigirtzoglou at JPMorgan estimates the immediate costs to the Eurozone at about ‚Ǩ395bn, made up of ‚Ǩ240bn through the international bailouts of the country, ‚Ǩ130bn through “Target 2‚Äù lending from other Eurozone central banks and ‚Ǩ25bn from commercial bank lending. These costs are very large, but probably manageable ‚Äì and the holdings by Europe’s banks are now relatively limited (although not so limited as to avoid further capital raisings, as argued above). The real concern, in our view, is what a Greek exit would mean for the remainder of the Eurozone peripherals. A Greek exit would immediately raise fears of which country would be next to turn its back on austerity and leave EMU. With the austerity zeitgeist fading fast (witness the recent collapse of the government in Holland, the election of Francois Hollande in France on a so-called growth platform and even regional elections in Merkel’s own Northern Rhine-Westphalia in Germany last week, in which the ruling Christian Democratic Union won its lowest share of the vote since its founding in 1945), the bond markets will be very chary of deviations from existing austerity programmes. Unless the ECB is ready to step in aggressively to buy peripheral sovereign debt, the result could become a self-fulfilling prophecy. Further out, once the storm has settled, the other peripherals may decide that the Greek route was indeed the correct one, and consider taking the same path. And while a Greek exit looks manageable on the numbers above, an Italian, Spanish or French exit would be unthinkable.

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