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

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

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  ...?

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