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The recovery in the euro area,
0inally!
SPRING 2015
The liquidity party is in full
swing in the 4inancial markets.
The European Central Bank took
the baton on the Fed to
boost growth in the euro area.
Hence, the recovery settles in
the euro zone, while it
continues in the United States and
shows up in Japan. Emerging
countries are no exception,
especially those that bene4it from
the oil counter-‐shock, which
provides tremendous support to the
global economy. Growth without
in4lation ? Financial markets love
it. Though, what is the price
for such in4lation-‐less growth
bonanza ? As with all good
things, excess is the enemy of
good. And do we account for
4inancial excesses ? You are
going to laugh.
Can you laugh at 0inancial
markets?
Mario Draghi can show all his
good humor: growth is back in
the euro area. Laughing
all the way to the top, the
President of the European Central
Bank brings us to its peers
on the other side of the
Atlantic. As a matter of
fact, Bloomberg just published a
funny indicator: from publicly
available recordings of meetings
of the Fed, it counted the
number of laughs among governors
in the US central bank's
sessions. The graph shows a
peak at 80 cheerful events
in July 2007, just before the
start of the "Great Recession".
Subsequently, laughing gradually
disappears from the Fed scene
... until March 2009, when
the stock markets hit bottom to
bounce back at full speed to
the heights of today. Too
bad the recordings of Fed
meetings are only available with
a delay of 5 years ...
This suggests that laughter are a
good "contrarian" indicator. Good
humor would tend to settle when
stock markets are close to
their peak. Proof, some major
investment icons like Warren Buffett
use laughter to identify
speculative bubbles. "If I want
to laugh when I discover
the price per square
meter in Florida to get a
view of the sea, I prefer
to let myself be lulled by
the lapping of the water in
my tub drinking a good beer"
puts it, not without malice,
the oracle of Omaha.
If a Governor is to frown,
that's James Bullard, president of
the St. Louis Fed. In a
recent interview, he said that
Winancial markets were running
to disaster, and that, due to
the ultra-‐loose monetary policy of
central banks, starting with the
Fed. Oh, by the way, the
governor has no right to
vote for monetary policy decisions
of the US central bank…
We will take a look at
the bubble danger on Winancial
markets, following the economic
outlook.
The ECB winning bet
The good humor of the
President of the ECB has
obviously much to do with
recent evidence of improved economic
conditions in the euro area.
The President of the ECB may
well relax
Number of laughter recorded during
the sessions of the Fed
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The keystone for healthy
transmission of monetary policy to
the real economy lies in
credit to households and especially
businesses. Generally under-‐capitalized,
commercial banks in the euro area
have so far hesitated to embark
on a truly expansive credit
policy, preferring the so-‐called
strategy of "Sarko trade", i.e.
the use of funds provided
cheaply by the ECB to buy
sovereign bonds. Suggested by the
former French President, this
operation has proved especially
rewarding following the famous speech
of Mario Draghi in July 2012,
whereupon he declared the
readiness of the ECB to do
“whatever it takes” to preserve
the integrity of the euro.
Today, sovereign bond yields are
not rich enough to encourage
banks to pursue this strategy.
Even riskier bonds such as
those of Italy and Spain
offer outright less yield than
their US bond peers. Not to
mention sovereigns bonds which
prove “sovereign” not merely in
the name, such as Germany,
which themselves show downright negative
yields.
In this context, commercial banks
are turning more to their
core business of granting credit.
As evidenced by the chart, the
evolution of bank credit in
the euro area has returned to
positive territory for the Wirst
time in 3 years. In
detail, it is mainly the business
loans that are favored, which
bodes well for investment and
future economic growth. The
latter is expected to reach and
exceed 2% in the euro area,
helped by a sharp rise in
consumer conWidence, which is not
far from the historical record,
as evidenced by the graph
below. InWlation is still negative
in the euro area, but the
threat of deWlation recedes,
unlike Switzerland, where the threat
has been strengthened by
the surprise decision by the SNB
to abandon the currency Wloor
of the euro.
Financial markets especially appreciate
the good news that they are
not discounted. In this respect,
it is interesting to follow
the economic "surprises" indicator
in the euro area: the blue
curve in the attached graph
is an average of the
differences between a range of
economic variables and their
corresponding expectations. In positive
territory, the curve shows
realized Wigures exceeding expectations.
This is the case since the
beginning of the year, a
trend that explains the acceleration
in the rally of the European
stock market.
Credit restarts in the euro
zone
European consumers show their good
mood
Stock markets appreciate surprises
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Of course, the scenario of a
Greek exit from the euro
zone would tarnish all these
good news. The probability of a
"Grexit" has increased to the
point that the worst case
scenario can not be ruled out.
However, I do hope that
politicians of all stripes will
get their act together to
maintain the integrity of the
euro area.
In the US, growth prospects
remain good. The employment Wigures
show a real improvement, and
even if the Fed has abandoned
the goal of 6.5% for the
unemployment rate, a threshold below
which it must raise interest
rates, it will be probably do
so during the summer.
Albeit timidly, the recovery also
rears its nose in Japan.
Consumers stomached the substantial
increase in the VAT a year
ago and the central bank
continues its expansive policy to
the extreme. As a matter of
fact, the Japanese driver of
growth lies in jumpstarting exports
via the weaker yen resulting
from the BoJ policy. This
will continue to be the case
as long as wage growth remains
below that of inW lat ion, a
natural brake on household
consumption.
In emerging markets, the economic
outlook differs greatly depending on
whether the country is an oil
importer or exporter. The
reference here remains China, a
heavyweight of growth in emerging
countries that is going through
a soft landing.
A bubble in stocks or bonds
...?
I came across one of my
columns, written in August 1999,
entitled "Champagne or sparkling
wine? ". I was illustrating
the danger of purchasing shares
if the main reason is that
bonds are expensive. Buying
champagne at skyrocketing prices mainly
because of sparkling wine prices
are also excessive can be
tricky.
What about today? The graph shows
that, at nearly 18 times
expected earnings for the next
12 months, the valuation of
the US stock market is not
signiWicantly higher than its
historical average, and much lower
than the level recorded during
the tech bubble in early
2000. However, one should take
this yardstick with a pinch of
salt, and this for three
reasons. First, it is based
on analysts' estimates, which we
know can suffer from "irrational
exuberance", to use the cult
words of former Fed former
Chairman Alan Greenspan. Second, the
projected proWits on a 12-‐month
period may be too short, given
their signiWicant cyclicality. Finally
and most importantly, proWits
projections are based on proWit
margins, which are strongly
linked to the business cycle. With
the boom that is experiencing
the U.S. economy, corporate margins
are at their peak, and
earnings expectations are probably
overestimated.
Other measures such as “Cyclically
Adjusted Price Earnings” ratio
("CAPE or Shiller PE"), or
market capitalization ratio to GDP
(a fetish indicator of Warren
Buffett) are in the red, in
that they are not very far
from the fateful threshold of
2 standard deviations above the
historical average.
Today, many investors – both
private and institutional -‐ turn
to equities for lack of better
alternative. The phenomenon is
not surprising, given the rock
bottom level of bond yields,
which is only a mirror
reWlection of the extreme dearness
of Wixed income investments.
When comparing equity to bond
yields, the temptation to be
invested in the former is
irresistible. But between the
Wizzy bubbles of champagne and
those of sparkling wine, sometimes
you just need to choose
those less speculative, of Coca-‐Cola.
Michel GirardinEconomic Advisor
The US stock market: reasonably
expensive, but ...?
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Short-‐term and 0ixed-‐income
When will the rate hike come?
Janet Yellen continues to
skilfully side-‐step the matter of
the timing of a US key
rate hike. And yet the US
economy is on track, with only
the inWlation Wigures below targets.
We are projecting a late
Fed rate hike decision, in the
second half of 2015. In Europe
and Japan, extremely accommodating
monetary policies are likely to
keep rates at historically low
rates for a long time to
come. Ten-‐year sovereign bonds
are currently yielding about 2%
in the US and 0.3% in
Germany. Against this backdrop, the
quest for returns is entering
a crucial phase, in which
risk appetite could take precedence
over caution. We are keeping
unchanged the allocation of our
balanced portfolio, underweighting
investment grade government and
corporate bonds and overweighting
high yield (18%) and convertible
(6%) bonds. We have reduced our
store of cash gradually, from
22% to 12% in order to
invest in other asset classes.
Equities
The US economy continues to drive
global growth despite slowing since
last autumn. Euro zone Wigures
have improved recently, reinforcing
forecasts of an upturn; the
Japanese economy continues its slow
recovery, and the main emerging
economies remain sluggish. Against
this backdrop, the best prospects
for market gains are in the
euro zone and Japan, driven
by ambitious monetary stimulus plans.
The US market seems to be
able to support a historically
high P/E ratio of more than
18x. We therefore decided earlier
this year to raise the equity
portion of our balanced
portfolio from 44% to 50%. We
are overweighting Europe (19%), the
US (18%), and Japan (7%)
and are underweighting emerging markets
(5%), focused mostly in Asia.
Currencies
The slight weakening in US growth,
combined with prospects of an
economic upturn in Europe, called
a temporary halt to the US
dollar’s rally, after an almost
straight-‐though 24% gain since the
start of 2014. We took our
proWits by selling half of the
long dollar position initiated
last November and are keeping our
USD exposure at 10%.
Alternative
In an environment of all-‐time
low bond yields, some alternative
investment strategies continue to
offer performances comparable to
past bond performances while offering
low risk. These equity and
Wixed-‐income pair-‐trade strategies are
keeping market exposure at neutral
at all times. We have
allocated 10% of the assets
of our balanced portfolio to
these alternative investments.
Outlook
In a global environment of weak
demand and low inWlation, the
slow slide in bond yields is
generating growing appetite for
risky assets, equities in particular.
As long as interest rates
remain close to their current
levels, equities will continue to
outperform, even if they have
to remain in overvaluation zones
for a long period of
time. However, risk appetite won’t
last forever. Use it but don’t
abuse it.
Armand du PontaviceCIO
Investment Policy