Mouhammed Choukeir, Chief Investment Officer
Animal spirits - February 2012
Crisis, what crisis? 2012 is off to a good start with risk assets performing incredibly well so far this year: global equities are up 5.0 per cent; investment grade and high yield bonds are up 2.3 and 3.7 per cent respectively; emerging market bonds are up 6 per cent; the euro is up 1 per cent versus the dollar; gold is up 11 per cent; and even Italian 10 year bond yields are back below 6.0 per cent having reached 7.2 per cent in November 2011.
So what has changed since last year? From a fundamental point of view, very little - sovereigns still have mountains of debt while continuing to run huge deficits, and austerity plans are likely to stifle growth. In spite of all this, ‘animal spirits’ are high boosting investor sentiment and market returns. Animal spirits is a term coined by John Maynard Keynes to describe human behaviour. According to Keynes “a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations... [animal spirits are] a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” Being negative is tiring, and investors are somewhat weary of being as bearish and gloomy as they were for most of 2011. This combined with a number of developments in financial markets turned the glass from half empty to half full in January.
The Long Term Refinancing Operation (LTRO) introduced by the ECB on 8th December 2011 was considered by some as a game-changer. Banks borrowed nearly €500 billion from the ECB which helped ease financing pressure in the intra bank market. It is worth remembering however that €350 billion came from rolling existing short term borrowing. Moreover, many banks borrowed the money with one hand only to put it back on deposit at the ECB with the other to pre-fund their own bonds which come to maturity in the near-term. Nonetheless, the LTRO has vanquished some of the tail-risk from the banking system, and on 29th February, the ECB is expected to make another massive provision with some analysts forecasting an LTRO take up of up to €1 trillion.
Mr Bernanke and co. also provided the markets with a reason to be cheerful in January, when the Federal Reserve published its inaugural report of economic projections and interest rate forecasts. On the face of it, the report suggests rates will remain unchanged till 2014 indicating a continued policy of quantitative easing by announcing a third round of treasury purchases. However, whilst the majority of Fed members voted in favour of this, 6 out of the 17 members called for rates to be hiked this year and next. So although another round of quantitative easing would also support a risk-asset rally, this is by no means a done deal.
Additionally, signs of an economic recovery eased concerns about a double-dip in growth. Leading indicators in the form of Purchasing Manager Indices (PMI) have picked up in recent weeks pointing towards economic expansion. Non-manufacturing and services PMIs in the US, UK and Europe are all above the 50 mark which draws the line between expansion and contraction. Although evidence supports the assertion that a reading above 50 is associated with future economic growth, it does not provide us with any information about forward returns in equity or bond markets. Our empirical work shows that there is no relationship between PMI data and forward returns both for equity and bond markets – we therefore cannot draw any useful inference from it to help us manage our exposure.
The LTRO, QE3 and PMIs - acronyms that have fuelled investor confidence in recent weeks - may continue to feed the market rally. However, we revert back to our investment process and focus on valuation, momentum, sentiment and economic climate to help us navigate market risks and make prudent investment decisions.
The US equity market recently re-established a positive trend, but it remains overvalued and overbought with over bullish sentiment, leading us to maintain our negative view on the market. UK equities on the other hand are much more compelling. The market is cheap: trailing dividend yields are 3.7 per cent relative to a historic median of 3.3 per cent; and price-to-book is at 1.6x relative to a historic median of 2.2x. Additionally, the FTSE 100 recently triggered a positive momentum signal suggesting an uptrend has been re-established. Moreover, although growth is likely to be challenged this year, policymakers are willing to step up the stimulus. Another round of quantitative easing in the US might not be guaranteed, but in the UK, it is. On 9th February, the Bank of England (BoE) increased its asset purchases by £50 billion to £325 billion. Our work shows that the FTSE 100 reacts positively to quantitative easing from the BoE. Therefore, favourable policy action combined with positive momentum and cheap valuations lead us to remain positive on UK equities.
Despite our stance on UK equities, we remain broadly defensive in portfolios. One reason for this is that the potential for disorderly default in Europe is still non trivial. The Greek drama is far from over. Clearly passing the Greek austerity measures through parliament was a positive step and a necessary precondition for the Troika (ECB, IMF, and EU) to approve the second bailout package and for PSI (public sector involvement) negotiations to resume. Agreeing on bond haircuts and austerity packages is one thing, but writing the cheques is another. There is increasing opposition and reluctance from other European and budget-constrained governments to open up the coffers, which could lead to a messy default. Investors seem complacent about this important risk.
Nonetheless, the market may continue rallying, and we will participate given our exposure to risk-assets, albeit to a lesser extent than broad equity indices given our defensive stance. Glimmers of hope may have developed animal spirits to boost market sentiment and risk-assets, but we prefer to only take risk when risk is well rewarded. That only happens when valuations are compelling – following this philosophy leads to better outcomes than a strategy of buy-and-hope.
This note is intended to give an insight into the thought processes that lie behind our investment views and our investment strategy. They do not necessarily reflect the current investment policy of Kleinwort Benson. This note is intended for information purposes only and does not take into account the investment objective, the financial situation, or the individual needs of any particular person. Investors should obtain independent advice based on their own particular circumstances before making investment decisions.