Download mm/file/2pm (Suisse) SA - Investment letter June 2014(1) - i

"BULL", "BEAR" OR "PANDA"?
The market may be bullish or bearish. For the moment it looks rather like a giant
panda in captivity.
No one disputes the thesis of
investments. This change in
faced with the threat of a
a market rally powered by
preferences could become a
collapsing Euro system, and
expansionary
durable trend, and this is why.
the skyrocketing safe haven
monetary
policies. Some are hoping
that
a
sustained
macro-
assets, like the Swiss Franc.
A WELL BRED BEAST
economic growth and a very
Then,
the
ultra-expansionist
progressive ascend of interest
First there were the long series
Japanese policy of PM Abe
rates
will
support
current
of
Easing's”
to emerge from 20 years of
prices.
Others
which pulled down US interest
deflation propelled the Nikkei
anticipated a dive of the
rates and the Dollar, while the
by
bond market which did not
perception of country risk in
depreciated the Yen by 20%.
happen yet. But no one really
America
knows
intact.
securities
how
exactly
unprecedented
the
transition
from of a policy of long
“Quantitative
was
These
more
than
60%
and
remaining
interventions
Finally, the phasing out of the
biased the risk and return
"Quantitative
relationship
reassured investors about a
and
pushed
Easing"
lasting negative real rates
durable resumption of growth
towards a more conventional
in the United States, and
policy will work. A wait-and-
The giant panda is a
interest rates hit 2% again in
see stance prevails among
mammal, pampered by the
May 2013. The free fall of gold
shareholders
and
bondholders, who had their
equity
gaining
months
and
14%
their
in
12
bonds
indices rising 3% in the same
Chinese and Japanese. In
captivity, it is bred with
bamboo
despite
its
price last year was in part
rationally
related
to
the
anticipations of a tapering.
Nevertheless,
the
opened
investigations and complaints
carnivorous nature.
period. Nonetheless, since the
against many banks (Société
first announcement by the
investors to accommodate
Générale,
FED of a tapering, in June
investments
more
Barclays, Bank of Nova Scotia
2013, some trend reversals
risky, like emerging countries,
and HSBC) confirm that the
appeared in different market
while justifying their sudden
magnitude
sectors.
appetite
the
decline was also linked to a
growth
massive price manipulation,
These
described
further
simultaneous
deemed
for
risk
argument
of
events, which are apparently
differentials
independent
regions(however
from
each
other, may have a common
denominator:
with
between
valid
over
the very long term).
we
had
the
reassuring statements and the
appetite
measures
safe
haven
based
of trade.
Then,
and consequently the reborn
for
we
European
taken
Central
of
had
on
gold
Bank,
price
suspected
improbable
intraday quotes and volumes
the
normalization of risk aversion
which
Deutsche
by
the
Bank,
Paolo Campolo, CFA 03 June 2014
JUNE 2014
SIGNS OF WEAKNESS
Margin
trades
are
leveraged
securities
purchases by borrowing
from the brokers. Margin
debt moving averages
ratios
formed
similar
peaks months before the
bursting of the internet
and subprime bubbles.
Beyond any hazardous
prediction of a crack, this
is surely another valid
proof of a decreasing risk
appetite.
After May 2013, some curious
market trends also started,
indicating
all
but
market
confidence:

Increasing risk aversion:
(Figure 1) The emerging
bonds
and
their
currencies tumbled. If the
returns of US Treasury
securities increase for the
same level of risk, the
return
of
emerging
countries must do the
same. Thus, the current
price
of
emerging
countries securities must
go
down.
The
normalization of the risk
and return relationship in
Treasury securities was
transferred immediately
to other asset classes.
(Figure 3) In May 2013 the
Swiss Franc started a rally
against the Euro and the
Dollar.
(Figure 2) in January 2014
gold
reversed
its
downtrend.
Strangely
enough, the safe haven
investments were gaining
ground again.
(Figure 6) While the 10year Treasury rates started
to go down in May 2014,
utilities and staple, the
non-cyclical
sectors,
suddenly
had
the
preference
over
technology or discretionary
goods, as doubt was
mounting
about
the
coming economic cycle.
(Figure 7) We discovered
a recent sharp contraction
of the aggregated margin
debt volumes in the New
York Stock Exchange after
reaching historic highs.

Lower rates expectations:
(Figure 2) From early 2014
the 10-year US Treasury
interest rate undertook a
descent, which means
that investors doubt that
long term rates are due to
increase
systematically
as a consequence of an
economic recovery.
(Figure 5) In Japan,
despite the return of
inflation hitting 3% in the
first quarter of 2014 under
the
effects
of
the
monetary policy and the
increase in VAT, the JGB
interest rates remained
virtually unchanged. This
reflects a clear distrust of
the Japanese themselves,
main buyers of their own
debt, regarding future
rate hikes under the
recovered
inflation.
(Figure 4) The evolution
between the commodity
and
S&P500
indices
became convergent and
decorrelated.
This
configuration
was
observable during periods
between 1997 and 2000
and between 2006 and
2008, prior to the bursting
of
the
internet
and
subprime bubbles. It says
that the interest for raw
materials
assets
is
growing among investors
at the expense of income
assets. Meaning a revision
of expected fixed and
variable income returns.
By evidence, the markets are
pricing in both low long term
investment rates and a higher
risk aversion.
THE GIANT PANDA, AN
ENDANGERED SPECIES
How can we explain these
hesitations while the consensus
among
financial
remains
very
analysts
optimistic
concerning the future growth,
especially regarding the USA
and China?
The Ukrainian conflict or the
threat of deflation in Europe
(with price growth of only 0.5%
in May requiring ECB action) do
not suffice to explain the flat
interest rates in the USA and in
Japan
or
between
the
decoupling
margin
debt
and
stock market indices. Therefore,
we may need to seek the
reasons
of
this
mistrust
elsewhere. There must be a
recognized systemic risk factor
that
creates
uncertainty
because monetary authorities
may be forced to keep rates
low in spite of ramping inflation
and growth.
Since 2008, governments and
central
banks
were
fighting
against systemic risks in the
banks sector. It is still hard to
say whether some dead cats
remained in the closets. The
recent
outrageous
JUNE 2014
manipulations of gold price,
between
foreign exchange and Libor
and the anvil.
one
deal
rates casted doubts about the
hand, rising interest rates could
With
integrity
large
jeopardize their chances to
demographics, the fear of a
institutions. There may still be a
meet their bond obligations.
bursting bubble in China and
significant
but
On the other hand, inflation is
Asian partners who purchase
that
the lesser of two evils, as it
35% of Japanese exports (the
reduces the burden of debt.
last 'Global
financial
of
these
systemic
players
risk,
know
nowadays massive injections of
the hammer
On
the
liquidity are commonly used
broad-spectrum
with these obligations.
a
moribund
Housing
Watch'
report by the IMF reveals the
to
(Figure 8) When we simulate
risks of the current global real
avoid domino effects within the
the impact of an interest rate
estate
interbank system.
hike of 2%, based on the
Hong
existing debt and budgets of
Malaysia,
Some point an accusing finger
the USA, Japan, France and
and Indonesia at the top of
at the derivatives market. But
Spain,
countries with the largest price
only a minority recognized yet
seriousness of the problem. The
escalation
the
simulation of the capacity to
unbearable
pay interest, takes into account
dependence
the following parameters:
and
1.
A growth rate of national
expenditure and revenues
equal to the currently
budgeted GDP growth.
A sudden increase in
interest rates of 2% in the
first year.
The current structure and
average maturity of the
national debt maturity.
expensive
things
we
consequences that go beyond
Obviously, there will be a limit
calculate the evolution over 10
the economy. The financial
sometimes.
this
years of Interests to revenues,
world
question is not yet a widely
debt to GDP and Deficit to
Japanese politicians on their
shared concern topic. On the
GDP ratios assuming that debt
achievement
other hand interest rates could
increases with the prior year
monetary
policy,
well be the true source of
deficit:
breeding
and
huge
therapies
imagine a stifling tax burden to
systemic
risk
it
represents.
There is however a major risk
known to all. It is the impact of
the dizzying debt, as a direct
consequence of the multiple
bailouts
and
2.
economic
stimulus. It has been extensively
3.
discussed whether the USA will
be
able
to
national
increase
debt
their
indefinitely.
However,
All
we
realize
being
equal,
the
concern because it poses a
risk to the stability of the
markets. The direct effects of
rising interest rates on the cost
of national debts, is worrisome.
The rates hikes are the corollary
of inflation much sought by
central bankers, according to
their mission of price stability.
Sadly,
most
economies
that
developed
tested
the
monetary expansion are now
bubble
Kong,
the
with
China,
New
Zealand,
Australia,
Thailand
in
2013),
an
energy
after
Fukujima
reminiscences
militarization,
of
the
end would more resemble the
Sepukku of the Emperor than
the last sighs of the giant
panda. Japan is still the third
biggest economy in terms of
GDP. A Japanese shipwreck
would
have
immeasurable
may
congratulate
through
but
raising
their
after
the
market beast in captivity, this

Japan:
Japan entered a budgetary
impasse. Already half of the
income is used to pay the
is masking the destruction of
the species' natural habitat.

USA:
interest on the debt. A sudden
The
2% rate hike increase would
capital factors in the USA mark
force Japan to dedicate all of
them out as a very resilient
its revenue to the service of
economy
debt in 8 years, with a debt to
GDB ratio of 300%. One can
flexibility
.
of
work
However,
and
an
interest rate increase could
plunge US into costs of debt
JUNE 2014
equivalent
to
20%
revenues.
The
of
the
numbers
of
Well before the deadline of an
imbalance
of
a
national
Spain, two years ago in the
treasury, the citizens will protest
middle of the “PIGS” crisis.
for the withdrawal of public
services and foreign investors

France:
which
Despite a cost of debt which
could reach 40% of revenues in
8 years and a galloping debt
ratio, it still proudly bears the
AA rating from Standard &
Poor's.
With
characteristics,
a
these
sneeze
of
global growth would put this
country at the edge of the
precipice.

due
to
the
100%
increase of public debt in 12
months and despite a structural
deficit of 3%, 3 times lower than
France. The simulation shows
that, all other things being
equal,
the
service
of
the
Spanish national debt could
total 50% of the revenues in 8
years, which is the situation of
bigger
simulation does not taken into
account the vicious circle of
the
growing
risk
premiums.
Therefore, under this additional
effect
Japan
would
go
bankrupt in much less than 8
years.
All these elements highlight the
of
recovery
Spain still suffers a BBB credit
require
guarantees for lending. Our
fragility
Spain:
rating,
will
in
the
economic
the
developed
countries and the imminence
of
the
problem
of
the
sustainability of national debt.
The investors do not ignore the
problem. They are progressively
pricing
in
this
risk
and
anticipating that rates will stay
low
to
avoid
the
fatal
outcome. Equity and bonds
which
have
not
yet
been
affected by the re-pricing may
well be the next on the list. All
Japan today. The estimate is
were expecting a decrease of
conservative because we do
obligations prices under the
not take into
effect of controlled rate hikes.
regions debt.
account
the
Now, they would better focus
on increasing risk premiums.
JUNE 2014
Figure 1
Figure 2
June 2014
Figure 3
Figure 4
June 2014
Figure 5
Figure 6
June 2014
Figure 7
Figure 8
Sources:
NYSE, Bloomberg, Financial Times, Standar & Poors, International Monetary Fund, Trésor Francais, Sénat, Ministry of finance
Japan, Heritage Foundation, OECD, Ministerio de Hacienda, Tesoro, Lombard Odier