February 2008 Investment Strategy Team 1 / 22 Written on 7 February 2008 INVESTMENT STRATEGY … IN SHORT Investors are nervous • At the end of February 6, the dollar-denominated MSCI World index had lost 10.4% since the beginning of the year. The financial crisis spread to emerging markets too, pushing the MSCI Emerging index down to -11.3% over the same period. The world's equity markets had already experienced a "black Monday" on January 21 (a national holiday in the US), which saw the major Asian and European equity indices suffer their sharpest drops since the September 11 terrorist attacks. • Volatility, as measured by option prices, remains quite high (more than 30% for the VIX index) and there have been large intraday fluctuations in equity markets. As an example, on January 22 the high/low spread for the CAC 40 index was 8.8%. A variety of concerns • Events over the past few weeks made new clouds appear on the horizon. At the start of the year doubts about the health of the US economy and fears of rising inflation (crude oil reached $100 a barrel) revived the scenario of a global recession. By mid-January, incoming earning reports released by US banks and the huge losses reported by some of them were sadly reminded us that the consequences of the subprime crisis were not going to vanish quickly. Fresh concerns about "monoline" bond insurers and their impact on credit markets then began to weigh directly on banks shares. • Against this background, efforts made by the Bush administration and the Federal Reserve to support the economy and the financial markets have not been very effective so far, as investors currently focus on risks and bad news. No major change to our allocation this month • There are however several fundamental reasons to return to equity markets: valuations are even more attractive after the recent fall in share prices, real interest rates stand at very low levels, the United States have undertaken massive monetary easing and fiscal stimulus, and finally the interbank market is gradually normalizing. • The high level of risk-aversion and the recent behavior of equity markets suggest that much of the bad news is already priced in and that share prices won’t likely drop further. However, a technical rebound does not seem to be taking shape, despite the strong message sent by the Fed in January. • We believe the wisest thing to do in the near term is to maintain our slight overweight in equities and a neutral position in government bonds. This prudent strategy should enable us to weather the tricky period that lies ahead, with softer economic data and concerns about corporate earnings. Then why not reduce exposure to equities? Because we are still convinced that the medium-term outlook for equity markets is positive and that such a move may prove regrettable in today's volatile markets. By that same token, we do not plan to add to our equity positions for the time being. • We therefore continue to adopt a prudent stance in the current environment, in terms of both geographic bets (hence our substantial overweight in the US) and sectors. We still recommend large-caps, particularly those that provide stable and high-quality growth.
Transcript
February 2008
Investment Strategy Team 1 / 22 Written on 7 February 2008
INVESTMENT STRATEGY … IN SHORT
Investors are nervous • At the end of February 6, the dollar-denominated MSCI World index had lost
10.4% since the beginning of the year. The financial crisis spread to emerging markets too, pushing the MSCI Emerging index down to -11.3% over the same period. The world's equity markets had already experienced a "black Monday" on January 21 (a national holiday in the US), which saw the major Asian and European equity indices suffer their sharpest drops since the September 11 terrorist attacks.
• Volatility, as measured by option prices, remains quite high (more than 30% for the VIX index) and there have been large intraday fluctuations in equity markets. As an example, on January 22 the high/low spread for the CAC 40 index was 8.8%.
A variety of concerns • Events over the past few weeks made new clouds appear on the horizon. At the
start of the year doubts about the health of the US economy and fears of rising inflation (crude oil reached $100 a barrel) revived the scenario of a global recession. By mid-January, incoming earning reports released by US banks and the huge losses reported by some of them were sadly reminded us that the consequences of the subprime crisis were not going to vanish quickly. Fresh concerns about "monoline" bond insurers and their impact on credit markets then began to weigh directly on banks shares.
• Against this background, efforts made by the Bush administration and the Federal Reserve to support the economy and the financial markets have not been very effective so far, as investors currently focus on risks and bad news.
No major change to our allocation this month • There are however several fundamental reasons to return to equity markets:
valuations are even more attractive after the recent fall in share prices, real interest rates stand at very low levels, the United States have undertaken massive monetary easing and fiscal stimulus, and finally the interbank market is gradually normalizing.
• The high level of risk-aversion and the recent behavior of equity markets suggest that much of the bad news is already priced in and that share prices won’t likely drop further. However, a technical rebound does not seem to be taking shape, despite the strong message sent by the Fed in January.
• We believe the wisest thing to do in the near term is to maintain our slight overweight in equities and a neutral position in government bonds. This prudent strategy should enable us to weather the tricky period that lies ahead, with softer economic data and concerns about corporate earnings. Then why not reduce exposure to equities? Because we are still convinced that the medium-term outlook for equity markets is positive and that such a move may prove regrettable in today's volatile markets. By that same token, we do not plan to add to our equity positions for the time being.
• We therefore continue to adopt a prudent stance in the current environment, in terms of both geographic bets (hence our substantial overweight in the US) and sectors. We still recommend large-caps, particularly those that provide stable and high-quality growth.
Investment Strategy February 2008
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ASSET ALLOCATION TYPICAL DIVERSIFIED MODEL PORTFOLIO – INSTITUTIONAL CLIENTS The model portfolio holdings below are measured against cash and may be transposed into any portfolio, whether benchmarked
t
Investment Strategy February 2008
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Overview of asset allocation - We continue to approach equities with prudence. Although lower interest rates and fiscal stimulus in the United States will strongly support financial markets, new drops in equity prices may occur given the current uncertainty, risks to growth and investor pessimism. - Neutral position in government bonds maintained. We believe that expensive valuations and inflationary pressures will limit further declines in yields supported by economic slowdown, monetary easing and the safe-haven status of government bonds. - We have reduced our underweight in high-yield bonds, given their more attractive valuations. - We have maintained our neutral position in commodities, along with our preference for gold and agricultural products over oil and base metals, the latter being more exposed to the slowing global economy. Geographic equity allocation - We have increased our exposure to North America. Even though we are concerned about the severity of the downturn in the United States, the fall in corporate earnings and the squeeze in margins, we believe the US offer a much more favorable policy mix than any other country. - We are maintaining a slight overweight in Switzerland, since the economy is moderately slowing and equity valuations have eased. However, we are wary of the Swiss market's high sector concentration. - We have adopted a more positive and neutral position in Japan. Although the country's economy is fragile and deflation remains stubbornly persistent, the prospect of rising earnings and margins, together with relatively attractive valuations are likely to support this market. - Slight underweight in the United Kingdom is maintained. Despite the lowering of interest rates, the housing market is slowing sharply and consumer-related sectors may face strong headwinds. - Underweight increased in the euro zone, whose economy will be hampered by the slowdown and above all the lag in monetary policy. - We have reduced our exposure to Australia, due to its overheating economy, inflationary pressures, monetary tightening and high valuations. - Among the Emerging economies we are rebalancing our bets between China, Taiwan and India, to the detriment of the latter in particular. The 40% correction in Chinese equities has made this market more attractively valued. We have increased our underweight in Korea, which is highly exposed to the US business cycle. Government bonds - We continue to prefer European bonds, where the BoE has begun to lower interest rates and the ECB will follow soon. Switzerland however is less attractive since the economic slowdown is limited and the SNB is on hold. - We underweight US bonds since this market is too expensive, as interest rates cuts and the economic downturn are already priced in.
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INVESTMENT STRATEGY FEBRUARY 2008
ECONOMIC ENVIRONMENT "AND NOW… WHAT WILL I DO?"
After lowering the Fed funds rates twice within practically a week, perhaps Ben Bernanke is humming Gilbert Becaud's famous song "What now my love"? Indeed, financial markets have been shunning the Fed's chairman advances, who may be feeling betrayed. All kidding aside, it may look surprising to see investors worrying about equity and credit markets, given the dynamism the US authorities decided to adopt in implementing economic policies. Although much of the current pessimism among investors is due to the slowdown over the last quarter of 2007, weaker confidence may also depress economic activity, and the longer this period of slowing growth persists the stronger confidence will be triggered down, thus spreading to the rest of the world. If, as we believe it will happen, the US were to recover in the second half of the year, investors will rapidly regain their calm.
A difficult period
The past few weeks have been marked by very high volatility in all financial markets and by key economic indicators much weaker than expected. This was the case of course in the United States when the jobs report and the ISM non-manufacturing index were released, in Europe, where the PMI indices for the service sector dropped sharply, and in Japan, where industrial growth is slowing. In the emerging regions the most cyclical economies are starting to feel the effects of softer demand from their developed trading partners. Does it mean that the global economy is on the brink of a recession, or perhaps already in one, as many market observers claim? Once investors in financial markets (especially bond markets) believe to this scenario the question becomes worthless. Global growth will no doubt be slower in 2008 than in 2007 and probably below potential, at least in the largest economies. Economic data over the coming months will certainly confirm this, and it is strange to observe that market participants are apparently surprised by bad news when they already expect a very severe slowdown.
A more encouraging outlook However, it is hard to imagine the global economy "stalling" for more than a year. For one thing, the current slowing of global demand will not prevent spending on major infrastructure projects in the emerging countries (particularly China and India), which should ensure relatively solid growth in these regions. As for the United States, its pragmatic use of fiscal and monetary policy should enable consumption and investment to recover in the second half of the year. The real estate sector, on a negative trend for more than two years, should also start easing its negative effect on growth. As usual, Europe's business cycle lags the US economy and this will continue to weigh on growth in the euro zone. A move by the ECB to ease monetary policy this spring may therefore bring some relief.
This scenario could however be compromised if the global financial system seizes up. This fear helps explaining current investor concerns about the "monoline" bond insurers in the US. If the worst had to happen, it will have dire implications for both the real economy and the riskier asset classes. Ben Bernanke and all other central bankers are well aware of the consequences, and would do everything possible to avoid them.
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INVESTMENT STRATEGY FEBRUARY 2008
ECONOMIC OUTLOOK:
UNITED STATES United States – bad news captures attention Surveys suffer from general pessimism. Although survey data on industrial output and orders show that the manufacturing sector is relatively well positioned for a recovery after the very large inventory drawdown toward the end of 2007, investors have been focusing their attention on disappointing economic data.
The Institute for Supply Management (ISM) surveys released in early February provide an almost textbook illustration of this. The manufacturing index rebounded to 50.7 (from 48.4 in December, a figure that was revised upward), a level that historically correlates with an annualised GDP growth rate of 3%. The index for non-manufacturing activity, on the other hand, suffered a spectacular drop from 54.4 to 41.9 and has rekindled doubts about the US economy's health. The sharpness of this decline is extremely surprising and was no doubt exacerbated by the weaker environment observed since the beginning of year.
Sharp slowdown. The US economy is indeed slowing and after sluggish annualised GDP growth of only 0.6% in Q4, growth is likely to remain weak for the first half of 2008. The general pessimism is affecting not only confidence but also survey data, which probably exaggerate the current difficulties. Moreover, other more encouraging data is being ignored. For example, the ISM asked its respondents this month whether the turbulence in financial markets has affected their capacity to borrow and their response was clearly no. Those who concluded that a credit crunch had arrived on the basis of the Federal Reserve's most recent survey of lending conditions (Senior Loan Officer Opinion Survey) may therefore have been a little hasty. Although GDP growth is already below potential and will be slower this year than in 2007, we expect it to gradually accelerate in the second half of the year.
Outlook for recovery. Despite some weakening as the year ended, private consumption growth in the fourth quarter was respectable (2%), although well below the average rate of 3.2% observed since 2004. The most recent jobs report was disappointing, revealing a net loss of jobs in
January, even though total employment continued to rise and was 0.7% higher than a year earlier. The labour market deserves close attention in this phase of the business cycle, and the overall climate may not only weigh on hiring intentions but more importantly on consumer confidence. The current conditions of the labour market (the jobless rate of 4.9% is near NAIRU) should prevent massive layoffs and sharp cuts in wages. Companies may also be expected to start reinvesting (at least to replace equipment) after a lacklustre 2007, which should also support the economy. Lastly, the housing market has been weighing on GDP growth for the past seven quarters. Although we do not expect a sharp rebound in the second half of the year, there is little chance that the situation will now get any worse since residential investment as a share of GDP has fallen to 3.7%, its lowest level since 1991.
Both monetary and fiscal policies will support growth. The "policy-mix" is becoming increasingly favourable. The Fed funds rate has been cut by 225 bp since September (including a 125 bp cut in January) and the fiscal stimulus plan that George Bush announced in mid-January is beginning to take shape with Congress's support. Monetary policy is quite accommodative. At 3% since end-January, the Fed funds rate is below the level recommended by the Taylor rule and very low in real terms, at only 0.6% as measured against core inflation. We expect Ben Bernanke to continue to ease policy, while adapting his tone to show that although he is ready to strike fast and hard he will also quickly normalize monetary policy once the storm has passed. We expect fiscal measures to be rapidly implemented and that households will start receiving their tax rebate checks in May. Much of this money will be spent, since the households targeted have a high propensity to consume.
USA: Industrial softpatch should be limited in time (y/y % change; 3-month moving average)
New Orders Nondefense capital goods excluding aircraft (Left) Manufacturing ISM (Right)
90 92 94 96 98 00 02 04 06500
1,000
1,500
2,000
2,500
3,000
-500-400-300-200-1000100200300400
Source: Factset, BNPP AM
USA: Important room for manoeuvre for a fiscal package(12-month sum in billions USD)
Budget Balance (Right) Total Outlays (Left) Total Revenues (Left)
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INVESTMENT STRATEGY FEBRUARY 2008
ECONOMIC OUTLOOK: EURO ZONE
The ECB is preparing to take actionThe same old routine, week after week. All eyes remain focused on the ECB, as financial markets anxiously wait for the Central bank to lower interest rates. After its meeting of 7 February, the Council of Governors decided to keep its refinancing rate at 4%, where it has been since June 2007. Although the main risk that Jean-Claude Trichet pointed out was "second-round" inflationary effects, he did ultimately recognize that GDP would grow below its potential rate this year and that the uncertainty of the economic outlook resulting from the financial crisis was "abnormally high". Indeed, economic activity continues to slow, both households and businesses are less confident and the downside risks to growth remain substantial, all of which makes it hard to assess the magnitude of the coming slowdown. Although the ECB has always been an inflation hawk, we expect it to end up following the Fed's example and loosen its monetary policy in response to the economic downturn and the gradual receding of inflation during the year. We therefore predict two 25 bp cuts in the refi rate this year, with the first made in April or May and at least one more two to three months later. By showing that he is much more concerned about growth, Jean-Claude Trichet has indeed begun to qualify his position and is preparing to take quicker action than might have been expected from his previous statements.
Slowdown, but no recession. The growth outlook has gotten a bit dimmer over the past few weeks. The fragility of the US economy, increasing tensions in financial markets and the acceleration of inflation caused by rising commodity prices are three new obstacles to growth, that come on top of past increases in interest rates, the euro's appreciation and the cooling off of the housing market.
Despite the severity of the recent shocks we expect the slowdown to be relatively modest, even though the risks remain to the downside. We expect GDP growth of 1.8% in 2008, after 2.7% in 2007.
Domestic demand factors, which remain solid, will partly make up for flagging exports and residential property
investment. The construction sector is already slowing markedly, particularly in Spain, where house inflation is rapidly decelerating, new housing starts are falling and construction employment is shrinking, all of which points to a hard landing in this country.
Tighter credit conditions and a dimmer outlook will weigh on business investment, which we expect will be used to achieve productivity gains rather than to increase production capacity.
03 04 05 06 07-10
-505
1015202530354045
Source: Factset, BNPP AM
Euroland: Credit standards for non-financial corporate and HouseholdsThe Euro Area Bank Lending Survey
Net % tightening in credit standards for Loans
House purchase, Expected development of approvalLoans or Credit Lines to Enterprises, Expected development of approvalConsumer credit and other lending, Expected develoment of approval
Consumers more vulnerable. The main pillar supporting growth is private consumption. Although the erosion of purchasing power has placed European households in a more vulnerable position – as may be seen by the decline of retail sales in the fourth quarter of 2007 and the drop in consumer confidence caused by surging prices – employment has been holding up well so far. Private consumption will be supported over the coming months by the strengthening of the jobs market (the number of unemployed has fallen almost 18% since January 2005 and the jobless rate of 7.2% in December 2007 was the lowest in 25 years) and the moderate wage growth expected. However, the second part of the year could prove to be more difficult, as the labour market begins to adjust to the slowing economy
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INVESTMENT STRATEGY FEBRUARY 2008
ECONOMIC OUTLOOK: UNITED KINGDOM & SWITZERLAND
United Kingdom – slowdown confirmed
The most recent figures still reflect a slowing economy. PMI manufacturing indices are sending a clear signal that this sector is no doubt running out of steam. Retail sales figures are also showing a clear downturn. Consumers, whose confidence is sinking to new lows, are becoming more and more cautious as they see property values decline. As a result, the number of home loans granted is also decreasing.
Housing slowdown finally catches up with consumption
But what is making the situation even more difficult are concerns about inflation, and in particular inflation expectations. With the PMI sub-indices showing that prices are still high, the Bank of England is faced with a dilemma.
Inflation fears have remained sticky so far
To what extent monetary policy can be loosened will therefore depend on the Monetary Policy Council's ability to keep inflation expectations in check. It will therefore be keeping a close eye on all relevant indicators. In any case, this is what may be gathered from the MPC's most recent meeting at which the BoE stated that it must balance the downside risks to growth with fears that inflation may remain durably above the bank's 2% target. The importance that the
BoE currently attributes to containing inflation expectations is reflected in the unusually long length of its statement.
Nevertheless, we continue to believe that the BoE will keep on gradually lowering interest rates, and expect 75 bp of further cuts in the base rate, bringing it to 4.75%.
Switzerland – growth near potential The robustness of Swiss household consumption will make a significant contribution to the country's growth and make up for the relatively moderate slowing of exports.
This is confirmed by leading indicators, which point to a relatively modest slowdown. We therefore expect growth to be near potential.
Surveys point only to a limited slowdown
Although the recent pickup in headline inflation could be a cause for concern, it may mainly be attributed to rising energy prices. We therefore expect inflation to return to a more modest level, particularly considering that unit wage costs remain well under control.
Under these conditions, we believe the SNB will keep its interest rates on hold, unless further depreciation of the Swiss franc requires it to take action.
KOF CONSUMER SURVEY: CONSUMER CONFIDENCE 4/2/08
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
35
40
45
50
55
60
65
70
-1.00
-0.50
0
0.50
1.00
1.50
2.00
2.50
3.00
SW PURCHASING MANAGERS INDEX SADJSW KOF ECONOMIC BAROMETER - ALL ECONOMY NADJ(R.H.SCALE)
HIGH 66.78 15/8/06,LOW 39.86 15/5/96,LAST 61.64 15/1/08 Source: DATASTREAM
4/2/08
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-40
-30
-20
-10
0
10
20
30
40
UK BUSINESS TENDENCY SURVEY: MFG. - FUTURE SELLING PRICES SADUK CONSUMER OPINION SURVEY: FUTURE PRICES SADJ
HIGH 25.00 15/5/07,LOW -30.00 15/1/99,LAST 19.00 14/12/07 Source: DATASTREAM
MAV#(ECSWF3M,2W) 4/2/08
2003 2004 2005 2006 20070
5
10
15
20
25
30
0
1
2
3
4
5
6
7
8
Halifax house prices index (YoY%)Nationwide House prices index (YoY%)Retail sales (YoY%)(R.H.SCALE)
HIGH 23.8 14/3/03,LOW 1.4 15/7/05,LAST 6.4 14/12/07 Source: DATASTREAM
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INVESTMENT STRATEGY FEBRUARY 2008
ECONOMIC OUTLOOK: JAPAN
Moderate growth
Considering the US economic outlook and the yen's strong appreciation, which continue to weigh on Japanese exports, we are expecting even weaker growth over the near term. Despite this however, we believe that exports, which remain the country's main growth engine, will continue to grow, thanks to the increase in trade with Asia and the other emerging economies, which now account for well over 60% of Japan's foreign trade. In contrast, business investment will stagnate due to a substantial decline in profits.
Japan: Job insecurity increases
Employment becomes precarious
Japanese consumers are still in the doldrums, with confidence at its lowest level since 2001. What is worse, the average Japanese household has no intention to purchase a durable good in the near future, a sure sign of consumer depression. There are several reasons for this loss of confidence. First of all, structural reforms in the corporate workplace have increased job insecurity, as full-time positions have been replaced with more precarious and less well-paid part-time jobs. This problem has been exacerbated by the current business cycle. Furthermore, the very sharp rise in energy and food prices has even further reduced purchasing power.
Small and medium-sized businesses are hardly any more confident than consumers. Unlike the large multinational companies, they are unable to take full advantage of the vigorous economies of their Asian neighbours, but still feel the full brunt of rising energy and commodity prices.
After falling heavily into negative territory, leading indicators have already begun to pick up, thanks to inventory accumulation and new residential investment. Although this of course means that a slowdown in economic activity still lies ahead over the coming months, probably due to private consumption, it may also mean that the worst is behind us in terms of expectations. We are already seeing tangible signs of a rebound in new housing construction orders. However, growth in 2008 will still be below potential and will not
encourage the Bank of Japan to raise interest rates very rapidly.
Emerging Asia will continue to grow at a robust pace of over 8% in 2008, and will not be significantly affected by the global slowdown and the consequent decrease in exports, according to the IMF's latest report. The growing contribution of trade to the region's economy has probably enabled emerging Asia to "decouple" from the rest of the world.
Asian economies are showing excellent fundamentals. Foreign exchange reserves and budget surpluses give ample room for fiscal stimulus if necessary to boost the economy, particularly in those countries that lack infrastructure and are least vulnerable to inflation. Furthermore, moderate inflation and often negative real interest rates should provide strong support to investment. This is particularly true of Hong Kong and Singapore. However, rising food prices are beginning to worry authorities in the ASEAN countries, in addition to China.
China: Beware of the recent harsh weather on CPI
After hitting a peak of 11.4% in 2007, Chinese economic growth continues to slow gradually. We expect that the slowing of the global economy and the government's measures to reduce exports will trim about 1.5% off GDP. Although Chinese authorities are still in monetary-tightening mode, the recent cold spell and snowstorms have encouraged them to proceed with greater caution. Indeed, the authorities will postpone all measures if the extremely harsh weather causes prices to surge and threatens the country's social and economic stability.
China's economic fundamentals are still quite strong. Domestic consumption jumped 20% last month, driven by rising wages and a favourable outlook for social security. The business sector, boosted by a cut in taxes from 35% to 25%, remains solid, and the government plans to continue with its massive investment plans. Under these conditions, we expect Chinese growth to remain vigorous and that any slowdown will be only temporary.
India: leading indicators are bottoming out
India's economy is quite surprisingly going against the global trend, and economists are revising growth figures upward. Domestic demand, which consists almost exclusively of private consumption and investment, accounts for over 85% of GDP growth, which we expect will be 8.3% in 2008. The country's IT industry may however feel the weight of the US economic slowdown, since it caters to a highly global clientele.
It is interesting to note that Korea, one of the most cyclical countries, saw its leading indicator reach a new low.
CH CPI (PREV. YEAR =100) NADJCH CPI: 36 MAJOR CITIES: FOOD - NAT.AVE.(PREV. YEAR =100) NAD
Source: DATASTREAM
(USPERSINB-USCNPER.B)/USPERDISB 5/2/08
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-4
-2
0
2
4
6
8
10
12
14
16
IN COMPOSITE LEADING INDICATOR: 6-MONTHS RATE CHANGE AT ANNUA
Source: DATASTREAM
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INVESTMENT STRATEGY FEBRUARY 2008
ECONOMIC OUTLOOK: IN EMERGING EUROPE & LATIN AMERICA
Emerging Europe
In Russia, investment, which has grown very rapidly over the past few years, should continue to do so. The country's need for infrastructure remains considerable, particularly given the very rapid rise in living standards. Furthermore, Russian authorities have clearly indicated their intention to step up investments over the next few years, notably by facilitating foreign direct investment. The almost certain victory of the candidate designated by Vladimir Poutine for the presidential elections in March and the prospect of political stability that this implies will also do much to attract foreign investors. With the jobless rate still relatively low and the growth in real wages (16.2%) and credit still quite robust, retail sales are quite understandably also growing at a very fast pace (16.7%). The emerging countries purchase half of Russian exports, while the United States accounts for only a small portion. We therefore expect oil and commodity exports to remain strong. Against this background of robust economic activity and rising food prices, inflationary pressures continue to be intense. We therefore expect inflation, which reached 12.6% in January, to remain high over the next few months. Since government authorities will continue to use foreign-exchange policy as their preferred tool against inflation, the rouble will remain strong. In Turkey, we expect inflation to gradually slow over the next few months, due to the country's stubbornly high unemployment rate which reduces upward pressure on wages.
Turkey: receding inflation will facilitate central bank's gradual monetary easing
Text
Titre.
The Turkish central bank will therefore continue its gradual monetary loosening in its effort to boost consumption. Indeed, despite the high inflation rate, real interest rates are still very high and are therefore dissuasive to consumers, whose confidence is still low according to the most recent opinion surveys. Over the medium term, and even though exports are highly dependent on Europe's slowing economy, we believe the combination of slowing inflation and monetary easing will enable consumption to recover. We therefore expect growth to accelerate slightly in 2008.
Latin America Mexico cannot remain unscathed by the marked downturn in the economy of its large neighbour to the north. Indeed, the United States still purchases almost ¾ of Mexico's exports, although this share has been decreasing over the past few years. We may therefore expect Mexico's growth to slow in the wake of the US slowdown, particularly since remittances by Mexican workers in the United States, often working in construction, continue to decline. Moreover, business surveys show a much dimmer outlook. This means that consumer spending, which has been robust until now, is clearly at risk, as the acceleration in both headline and core inflation will prevent the country's central bank from loosening monetary policy. Brazil, on the other hand, is in a much more enviable position. Thanks to a solid jobs market, retail sales (which are currently growing at an annual rate of 10%) will remain strong. The outlook for foreign trade is also good, since Brazil currently sells 60% of its exports to other emerging economies and therefore has relatively little exposure to the downturn in the US. However, the recent increase in inflation is likely to prevent the country's central bank from pursuing further cuts in interest rates over the next few quarters, thus leaving real interest rates at a very high level.
Mexico: US slowdown affecting both remittances and business confidence
MX HOUSEHOLD REVENUES FROM WORKERS' REMMITANCE CURNMX BUSINESS TENDENCY SVY: MFG. BUSINESS CONFIDENCE INDEX NADJ
Source: DATASTREAM
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INVESTMENT STRATEGY FEBRUARY 2008
BOND MARKETS GOVERNMENT BONDS
Neutral position maintained
Valuations are tight.. It is hard to look at the recent trend in US bond yields without feeling a little nervous. Two-year yields are below 2%, while 10-year yields are currently hovering around 3.60%. Unless we assume that we are in a serious recession and therefore that interest rates will drop further (which we do not believe), these yields are unquestionably low.
..but there is no rush to sell. However, given the uncertainty as to the current slowdown's potential severity and the Fed’s "panic mode" response to reassure financial markets and assert its determination to support the financial system, there is little chance of an imminent rise in interest rates.
It would indeed be unwise to go against the market right now. As uncertainty and nervousness make riskier assets less appealing, government bonds continue to be the classic safe-haven investment and it is probably too early to get rid of them just yet.
Nonetheless, besides the different factors that support bond investments over the near term, we must also look at more fundamental considerations that may affect interest rates. We may note, for example, that "fair value" models based on growth and inflation still show that US bonds are expensive, and that real yields are still very low.
Outlook. If we assume the economy will pick up after the first half of the year, then we must expect higher interest rates in the second half. The size and pace of interest rate increases will inevitably depend on the vigour of this
recovery, which we believe will be more rapid in the United States, ahead of the euro zone and the United Kingdom in the business cycle. This movement will most likely be accompanied by a "bear flattening" of the yield curve.
The situation in the euro zone will probably be a little different. Interest rates already price some monetary easing to come, although less than that undertaken by the Federal Reserve, in line with the different behaviour of the two central banks. The modest steepening of the yield curve that has been observed until now may go no farther, unless further threats to European growth suddenly appear.
Neutral position maintained. For all of the above reasons, we prefer to maintain a neutral position on government bonds in general for the time being, with a relative preference for the euro zone over the United States.
In the United States, the carry between 10 and 2-year yields is still very profitable, but interest rate risk, although less menacing in the near term, remains a threat and we recommend a neutral duration position for the time being.
In the euro zone the interest rate risk is less intense, but the 10-2 carry is also less attractive, which is why we are maintaining a neutral yield-curve position. In the UK we recommend shorter issues, given the small spread between short and long yields and their general decline to below the forecasted BoE rate.
Interest Rate Forecast Summary % End of Period 2007 05-févr-08 1Q08 2Q08 3Q08 4Q08US Fed Funds 4,25 3,00 2,50 (4,00) 2,50 (4,00) 2,50 (4,00) 3,00 (4,00)
Source: BNPP AM as of 5/2/2008; Numbers in brackets indicate changes vs. previous update a month ago
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INVESTMENT STRATEGY FEBRUARY 2008
BOND MARKETS: BOND DIVERSIFICATION
High Grade – financials still offer good opportunities. High Grade bonds have generally outperformed over the past month, given the sharp decrease in the yields of government bonds of similar duration, of about 60 bp for 5-to-7 year maturities. However, credit market fundamentals have been much less favourable, with swap spreads widening once again after narrowing at the beginning of the year, and above all CDS index spreads above the record levels reached during last summer's credit crisis. And, unlike what happened last July, the cash bond market did not do relatively better (the cash/CDS basis fell). These developments may be explained not only by the renewed fears of a US recession, but above all by concerns about "monoline" bond insurers, which guarantee some $2,400 billion in municipal and securitized debt. The actual or expected losses on the portfolios of some monolines could cause them to lose the prime AAA rating they need to guarantee new issues. The spreads on financial issuers are now particularly wide and higher than those of non-financial issuers of equivalent credit-worthiness. We do not expect this unusual situation to last much longer and continue to have faith in good quality financial issues.
Corporate Bonds: Fair value model (bp)
High Yield – brighter days ahead? The high-yield market has slipped considerably since the beginning of the year. CDS index spreads are up almost 150 bp and are practically back up to last summer's highs. The underperformance of high-yield bonds relative to CDS was such that only the sharp decline in government bond yields limited the decrease in the aggregate value of HY bonds.
US High Yield Spreads and Yields
At their current levels, spreads in high-yield markets are slightly above their long-term trend. Issuer balance sheets remain solid, companies have relatively low funding requirements, and the default rate (which is still historically low) rose in January and could continue to do so over the coming months. Although the large overhang of unsold ABS and leveraged loans still weighs on the market, considering how oversold it is and the almost 10% carry trade, we have decided to take a slightly overweight position in HY bonds.
Emerging debt – watch out for overheating risk. Emerging debt spreads were volatile over the past month, but did trend slightly upward. The EMBI+ index is at about 270 bp, which is 20 bp higher than at the end of last year. The sharp drop in US Treasury yields did however enable the emerging debt market to post a gain for the month. Emerging debt has historically been quite responsive to changes in the fed funds rate, and the recent acceleration in rate cuts should provide strong support over the near term. The emerging countries are apparently well protected from the fallout of the US credit crisis. They could easily however be more vulnerable to a slowing of their exports to the United States and Europe. But the main concern for the time being is the overheating of their economies and fast-rising food prices. For some countries, the pegging of their currency to the US dollar poses a problem since it can force them to lower their interest rates in step with the Fed even though their economies should not be stimulated.
Under these conditions, we are going to be a little more cautious above emerging debt.
The year should be marked by a stronger dollar and a weaker yen
EUR/USD has been near 1.46 since January. Since the beginning of the year the EUR/USD exchange rate has been hovering around 1.46 and has been basically trendless despite the Fed's sharp interest rate cuts. The surprise announcement of a 75 bp cut in the Fed funds rate on 22 January however put an end to the dollar's strengthening and increasing status as a safe-haven currency after the drop in equity markets. Although the exchange rate during this period dipped below 1.44, at the beginning of February it was back up to 1.4950, or 2.5% higher than at end-December. The dollar's weakening seems relatively modest, considering that the Fed had cut its key interest rate by 125 bp in a week and has promised to continue monetary loosening, whereas the ECB has maintained a hawkish tone on inflation and Jean-Claude Trichet's statements in January have postponed any expectations of a cut in the refi rate. Uncertainty as to Central bank action and a rather hazy technical configuration largely explain exchange rate movements over the past few weeks, which reflect a wait-and-see attitude on the part of investors. In early February, Jean-Claude Trichet once again had an impact on exchange rates when he placed more emphasis on the downside risks to growth in his statement after the Council of Governors meeting of 7 February. This weighed on the euro and lowered EUR/USD to 1.45.
Growth, not interest rates. Investor behaviour has confirmed our belief that there will be a shift in the themes that drive exchange rates in 2008, with EUR/USD positions tending to place more emphasis on the growth rather than the interest rate differential, which should be good for the dollar in more ways than one. Initially, the very bleak scenario that some investors imagine for the US economy may result in a "flight to the dollar" and therefore its appreciation.
Then, it will quickly become apparent that economic recovery in the United States will precede any improvement in Europe. This lag in Europe's business cycle is traditional and could be even longer this time considering the very energetic monetary and fiscal response of the US authorities in comparison with their European counterparts, who do not seem willing to take such fast action. Against this background we continue to believe that EUR/USD could fall below 1.40 in the second half of the year and reach 1.36 by the end of the year. This represents an appreciation of 6% for the dollar, which is relatively modest in comparison with the 10% drops against the euro observed in both 2006 and 2007.
Let's forget about carry trades for a while. With volatility still high and many investors concerned about the financial health of the large US banks, the yen's appreciation in January (5% against the USD and 3.4% against the euro) may mainly be attributed to the repatriation of capital to Japan. This may have been accentuated by anticipation of the end of the fiscal year in March. In January, USD/JPY fell below 106, the lowest level since May 2005. The current climate of scepticism in all financial markets (except for government bonds) does not augur well for a pick up in carry trades based in yens or in other low-yield currencies for that matter. This situation is likely to continue for a few months until the yen starts to weaken in the second half of the year.
The Swiss franc also rose during the month (2.9% against the euro and 4.5% against the dollar) while sterling continued to decline, falling back 1.2% relative to a basket of currencies (according to the BoE's estimate) after slipping almost 5% during the last two months of 2007.
FX Rate Forecast Summary (Major Currencies)End of Period 2007 05-Feb-08 1Q08 2Q08 3Q08 4Q08USD Block EUR / USD 1,462 1,464 1,45 1,40 1,36 1,36
Source: BNPP AM as of 5/2/2008; Numbers in brackets indicate changes vs. previous update a month ago
14 / 22
INVESTMENT STRATEGY FEBRUARY 2008
EQUITY MARKETS DEVELOPED MARKETS
Slight overweight maintained, but still too early to increase exposure to equities We will be maintaining our very slight exposure to equity markets over the near term. We expect volatility to remain high over the next few weeks, with investors uncertain about the effectiveness of the "rescue plan" for US bond insurers, weaker economic data expected as the economy slows, and companies starting to report their 2007 earnings. Sharp drops in equity indices could therefore continue to fuel investor concerns about the ramifications of the subprime credit crisis and the risk of contagion.
Although equity markets will no longer be driven by vigorous earnings growth, there is certainly no reason to despair, particularly considering the speed with which US monetary and fiscal authorities have taken action. The spread of monetary easing to other central banks and, to a lesser extent, valuations that are attractive relative to government bonds lead us to adopt a positive medium-term outlook for equities.
Risks persist, but prices already reflect much bad news. Since peaking in late October, global equity markets, as measured by the MSCI World index in dollars, have fallen 20%. This correction is similar in magnitude to those that have generally been observed during US recessions since the end of World War II.
Indeed, the subprime credit crisis and its consequences continue to fuel investor fears that the impact on the real economy, particularly in the United States, will be greater than currently suspected. This climate of uncertainty has weighed heavily on the outlook for corporate earnings. According to our discounted dividends model, at its current price the S&P 500 index implies zero earnings growth over a medium-term horizon of 5 to 10 years. Earnings growth expectations have not been this negative since the late 1980s and seem to be excessively pessimistic.
S&P 500: Implicit EPS Growth (%) deduced from a 3-stage DDM
Earnings growth will slow. The 4th-quarter earnings of financial firms were once again severely impacted by large write-downs. The analyst consensus for financial sector earnings in the United States in 2007 now estimates a 23% drop, which will mean a 1.4% decrease in EPS for the S&P 500. Downward revisions of earnings growth forecasts for 2008 are still quite modest considering the speed of the economic slowdown. This, combined with an extremely favourable base effect, gives an EPS growth forecast of 16.8% for the S&P 500 in 2008. This bottom-up consensus is of course much too optimistic. Earnings will in fact continue to slow over the coming months, as the economic slowdown dampens sales and gradually puts more pressure on profit margins. Cyclical sectors are obviously most vulnerable to downward revisions in earnings forecasts.
There is one positive note however: outside of the financial sector, the earnings of US firms in Q4 2007, were quite solid, with 69% of the 235 S&P 500 firms that have reported their earnings exceeding expectations. Many CEOs however are warning that 2008 will be a tougher year, which does not seem surprising.
Bottom-up consensus - Main Financial IndicatorsEPS Growth (%) Dividend
Technical indicators send a neutral to positive message. Judging from the Put/Call ratio, market sentiment is still quite depressed, but is showing signs of improving. The Bull/Bear index recently reached a low, which generally means that a rebound in equity markets may be expected over the coming months. Although our risk-aversion index has eased back a bit over the past few weeks, it is still very high, suggesting that there is only a limited risk of a market correction. Our stress index, which has fallen back to an extremely low level, is sending the same message, but is not yet clearly signalling a near-term rebound.
US policy mix will be good for equities. Even though equity markets have lost the main engine that has been driving the bull market that began in March 2003, i.e. booming corporate profits, all is not lost, and the fast action taken by US monetary and fiscal authorities is reassuring.
In addition to the US policy mix, global monetary policy will be gradually easing, as suggested by the central banks of Canada and England, which have already started to cut their key interest rates. And we predict that the ECB will join them in the second quarter. This monetary and fiscal stimulus will provide strong support to equity markets over the medium term, once investors have a better understanding of the risks that banks, bond insurers and other shaky segments of the financial services industry are facing.
Valuations now attractive relative to other asset classes. According to traditional valuation multiples (trailing P/E and P/BV) developed equity markets are now trading at reassuring levels compared to their long-term trend. Some investors may object that since the EPS growth forecast 12 months forward is too optimistic, the 12-month forward P/E is too low (13.5 for the US) and does not accurately reflect the market's current valuation. Although this is a valid argument, even if we do we assume a sharp drop in EPS in 2008, of let's say 15%, the P/E for 2008 would still be about 18. This is still far below the high valuations reached during the dot-com bubble.
Relative to other asset classes, and to government bonds in particular, equities clearly appear to be undervalued. Risk premiums have increased substantially and are at their highest level in 20 years. The dividend yield model also indicates that equities are attractively priced.
Dividend Yield Model (BY - DY): S&P 500Trendline: 1 Year Moving Average with 1st moving standard deviation
Equities are « expensive »
Equities are « cheap »
16 / 22
INVESTMENT STRATEGY FEBRUARY 2008
EQUITY MARKETS DEVELOPED MARKETS
Overweight in US increased to detriment of euro zone. Japan is looking better
Even more enthusiastic about "Americans". This may seem surprising considering the many risks the US economy is facing, as explained above. But, the United States is not only very good at selling its riskier financial products, it also knows how to take fast and pragmatic action and assume some responsibility when necessary. And this is certainly the case today. The cut in key rates has been lightning fast and in our opinion is not over. Real inflation rates adjusted for overall inflation are already negative and may very soon be negative when adjusted for core inflation. Although this was the situation during the dot-com debacle, it was ex-post, i.e. after inflation figures had been revised upward! Furthermore, US central bankers and government authorities are working hand-in-hand to avert this new crisis situation, a feat that many of their counterparts in other Western countries must certainly envy. The government's emergency plan to aid the most indebted households and a large fiscal stimulus package will bolster the Fed's monetary policy.
In short, we continue to believe that this favourable policy mix will enable the US economy to gradually strengthen over the second half of this year. As history shows, it should also boost equity prices and therefore lead to a re-rating of P/Es. Of course some people may object that the scope for multiples expansion is limited by valuations, which are rather high if we take into account the weakening of future profits. We however do not feel this argument is very relevant since current equity prices have already largely anticipated a sharp decline in earnings.
Canadian equities still look good. We continue to be positive about the Canadian market, which offers strong earnings prospects that are still being revised upward. Although the sharply slowing economy of its neighbour to the south will no doubt be a drag on Canada's economy, the
impact of this will be reduced by revenues from commodities and the fast action of the BoC, which cut interest rates a further 25 bp in late January.
"Europeans" continue to lose their appeal. At last Mr. Trichet is making some concessions. In any case, it seems that the central bank he governs is preparing the stage for a gradual easing of monetary policy. Otherwise, what sense can we make of the rather alarming claim that "the uncertainty of the financial crisis' impact on growth is unusually high"! At best, we expect an initial rate cut in April, at which time the Fed will probably have already lowered its fed funds rate to 2.5%. Considering that financing conditions are now even less accommodative in comparison with the US, due to Europe's lag in the economic cycle, and that the euro-zone interbank lending market is taking a little longer to get back to normal (due to tighter monetary policy), we have decided to trim our exposure to European equities a bit more.
Swiss insurance. We have increased our exposure to the Swiss market slightly relative to the rest of our investment universe. In addition to expectations that Switzerland's economy will slow less sharply than the euro-zone economies and a relative improvement in valuations, the Swiss market's defensive sector composition could prove to be an advantage. However, the Swiss market is highly concentrated with the five largest market capitalisations accounting for almost 70% of the SMI's total capitalisation. Australia. We are reducing our exposure to Australia, whose central bank continues to fret about inflation risks even though its benchmark interest rate is already high at 7%. In addition, valuations are high.
@:USSP50C(A12PE) 5/2/08
83 85 87 89 91 93 95 97 99 01 03 05 07
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12 5
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US FEDERAL FUNDS TARGET RATE (EP)S&P 500 COMPOSITE - PER(R.H.SCALE)
Source: DATASTREAM
Further monetary easing will expand multiples
17 / 22
INVESTMENT STRATEGY FEBRUARY 2008
EQUITY MARKETS DEVELOPED MARKETS
Returning to Japan
Last month, we maintained our prudent stance on the Japanese equity market because we felt it would continue to underperform the other developed markets, due to its higher beta and Japan's highly cyclical economy. Since then, Japan has become very unpopular with investors and is oversold, which has encouraged us to adopt a contrarian approach and re-establish a neutral position.
The very sharp drop in Japanese equities in early January came in tandem with declines in the other developed equity markets, and was exacerbated by the yen's appreciation. The yen's strengthening may be explained by the unwinding of carry trades. If the yen remains at its current level, the impact on corporate earnings will be substantial. It should be noted that the yen has strengthened against the dollar from 117 to 107 in less than 12 months, and that this will reduce earnings growth by 5%, or half of the growth expected for 2008!
This correction brought Japanese equities back to where they were in 2001, a time when Japan was still synonymous with deflation and low corporate earnings. Yet, so much has changed since then! At its current levels, the Japanese market offers excellent potential. While consumers and companies are buying up depressed stocks, foreign investment funds continue to reduce their exposure to Japan due to the high degree of uncertainty in the current environment.
Japan: Waiting for funds flows to reverse
The market has not been this cheaply valued in 33 years, making it less expensive than some developed equity markets and Asia in general. The number of equities trading at less than 10 times forecast earnings has jumped to above 16%, and dividends yields are once again outperforming bonds. The last time this happened was in 1998 and 2001, two periods of severe crisis. At these levels, prices imply zero earnings growth and balance sheets and cash flow of dubious quality. This of course is not our opinion.
Japan: Good value is in the market
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G7 Consumer price indices 29/1/08
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NIKKEI 225 STOCK AVERAGE - PRICE INDEX(R.H.SCALE)Topix and net foreign buyers
HIGH 20726.99 3/4/00,LOW 7607.88 28/4/03,LAST 13087.91 28/1/08 Source: DATASTREAM
18 / 22
INVESTMENT STRATEGY FEBRUARY 2008
EQUITY MARKETS EMERGING MARKETS
After dropping sharply over the past few weeks, valuations in emerging Asian equity markets are once again reasonable. Although valuation multiples are still far above their long-term trend, they are reasonable considering the superior growth prospects and stronger fundamentals.
Historically, earnings growth in the emerging economies has been well correlated with the OECD's leading indicators, although it is true that cyclical variations have smoothed considerably due to the increasingly large contribution of domestic demand to GDP relative to exports. Although we may therefore expect downward revisions in earnings forecasts, growth will still remain above 10%.
Earnings growth too optimistic considering LEI?
Foreign investors fled Asian markets in January. The Chinese and Indian markets suffered the most from profit-taking, while Hong Kong and Taiwan were relatively spared from this due to their strong fundamentals and political situation. The spectre of a US recession is weighing heavily on the morale of investors who initially will not hesitate to return to riskier equity markets such as Asia.
After plunging 40%, Chinese equities listed in Hong Kong returned to a major support level that dates back to August 2007. Since the domestic Chinese market is ultra-speculative, has few institutional investors and is closely monitored by Chinese authorities, it is likely that a low point has been reached. We believe that the Chinese market, and above all the H-shares index, is in the process of forming a new base from which it will move on to a higher level. However, due to the global economic situation and the Chinese monetary cycle, there will be less potential for gain than in 2007 and greater volatility.
Chinese shares: rebounding on a support
We are maintaining a slightly positive bias toward India, given its domestic growth potential that will benefit such sectors as financial services, which moreover continues to post excellent earnings. It is also one of the few countries to have positive leading indicators.
We still like Taiwan for its low relative valuations and solid political outlook. The ASEAN countries offer the advantage of having little direct exposure to the United States.
Global LEI, 6 months forwardAsia ex Japan ibes 12 months fwd, yoy(R.H.SCALE)
Source: DATASTREAM
FROM 1/ 2/07 TO 1/ 2/08 DAILY
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HANG SENG CHINA ENTERPRISES - PRICE INDEXPERIOD HIGH 20609.100 LOW 8426.809 CLOSE 13284.740
Source: DATASTREAM
19 / 22
INVESTMENT STRATEGY FEBRUARY 2008
EQUITY MARKETS EMERGING MARKETS
Latin America and emerging Europe
Given the sharp slowing of the US economy, we believe that the earnings growth forecast for the Mexican market is much too high. It is currently above 20% for 2008, after small downward revisions over the past few weeks. It might therefore be wise to reconsider the idea that Mexico offers slightly lower valuations than its emerging peers, based on the forecast 2008 P/E. Furthermore, inflationary pressures will prevent the country's central bank from quickly cutting interest rates.
Even though the Brazilian market has been holding up better to the recent market turbulence, its valuation is slightly below the average for the other emerging markets, in terms of both trailing and forward P/E. However, the 2008 earnings growth forecast for Brazil is a bit lower than the average forecast for the emerging equity universe, despite the favourable economic outlook. Lastly, monetary policy, which we expect to be stable in 2008, will no longer provide support to the equity market.
The low valuation of the Russian market, which is significantly below the average for the other emerging countries, may provide good support to Russian equities in the current volatile environment, even though this lower valuation is mainly attributable to the energy sector's considerable weight in Russia's economy. Furthermore, the earnings forecast for 2008 has just been sharply revised upward and is now almost in line with the average for the other emerging markets. These earnings expectations reflect the still very positive outlook for investment and consumption and Russia's very small exposure to the slowing US economy, even though there is considerable pressure on margins.
After dropping sharply, the Turkish market saw its valuation fall to a very low 8 times projected 2008 earnings. And yet, earnings growth expectations remain much lower for Turkey than for the other emerging countries. We continue to believe that the odds are in favour of an upward revision in the earnings forecast. For one thing, the central bank's monetary easing will provide very strong support for consumer spending and credit growth. Secondly, financial firms, which account for half of the Turkish equity index, will benefit from the looser monetary policy and from the upgrading of the domestic debt on their balance sheets. Lastly, this monetary easing should also enable an expansion of valuation multiples.
After months of underperformance, the Polish market has gone from a valuation premium to a discount, relative to its emerging peers. Although the Polish economy remains solid thanks to robust consumption and investment, the economic slowdown in the euro zone, and particularly in Germany, could weigh on growth, which we expect will slow somewhat in 2008. This in conjunction with strong pressure on margins explained the substantial downward revisions in the earnings growth forecast for 2008, which is now less than 5%.
Turkey: still cheaply valued vs. other emerging markets
5/2/08
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MSGUSAL(RI) 4/2/08
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Rel 12-mth forward PE vs. emerging markets
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20 / 22
INVESTMENT STRATEGY FEBRUARY 2008
ALTERNATIVE STRATEGIES COMMODITIES
Oil – Neutral position for near term
After reaching a record $100/bbl late last year, oil prices tended to decline until the Federal Reserve cut interest rates on 22 January, which calmed fears of a US recession and enabled oil to bounce back and stabilize at around $90/bbl.
As expected, OPEC did not modify its production target at its meeting on 1st February and could consider a cut at its next meeting on 5 March, taking into consideration the more uncertain economic environment, rising crude oil inventories and weaker seasonal demand as winter comes to an end. We expect the oil price to remain near its current level over the near term.
Gold – higher still
The price of gold continued to rise in January, reaching an all-time record of $940 an ounce on 30 January. Since then, the strengthening of the US dollar has triggered some consolidation that temporarily brought the price back down to $890, before again rising to its current level of about $920. Despite the high price, jewellery demand for gold remains strong. Our outlook for this precious metal remains positive, given its status as an inflation hedge and popularity in India and China. Over the nearer term, we believe that gold is a good hedge against rising market risks.
Volatility should continue to support gold
Base metals – still rebounding
Despite fears of a global economic downturn, base metals have confirmed their upward trend that began at the end of last year, and have recovered half of their losses since last fall. Although various technical factors, such as temporary interruptions of aluminium and copper production in China caused by bad weather and power failures explain some of these higher prices, there may also be more structural factors at work, such as the relatively good health of manufacturing in the developed countries, and the increasingly autonomous economic growth of the emerging countries.
However, given the inventory trend – which continues to be unfavourable with the sole (and perhaps short-lived) exception of copper – and the new production capacity that is being built (for zinc in particular) we have decided not to overweight this asset class in the current risk-averse environment.
Agricultural commodities – higher still
Despite various factors that could have weighed on agricultural commodity prices, such as Argentina's decision to resume wheat exports, agricultural commodities continued to rise, with the S&P GSCI index up 15.7% year to date, and 52.6% year on year. It should be kept in mind however that prices have been very low over the past few years.
In addition, the use of corn to make biofuel and the inevitable change in eating habits in many emerging countries are two good structural reasons to invest in agricultural commodities. Lastly, their lack of correlation with other financial markets, due in large part to weather contingencies, make this asset class an attractive long-term investment.
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21 / 22
INVESTMENT STRATEGY FEBRUARY 2008
ALTERNATIVE STRATEGIES HEDGE FUNDS
Equity strategies – Long/Short and Market Neutral
History, and in particular recent history, has shown that long/short strategies may be highly correlated with equity markets over the near term, but also that fund managers know how to protect themselves against a prolonged bear market. We also know that the added value of a long/short strategy stems from both directional and relative bets. In the current environment, long bias strategies may therefore be penalized, and it would be prudent to underweight them over the near term. Under these conditions it is better to focus on more market-neutral strategies that can benefit from the increased dispersion of performances and reduce the drawdown risk.
Directional strategies – Global Macro
The momentum is definitely favourable for global macro strategies, which were among the best performers in January. We expect this trend to continue over the next few months, since fund managers may easily decide to avoid equity strategies and take advantage of trends in other asset classes, such as fixed income, currencies or commodities.
Event-driven strategies – Distressed and M&A.
Moody's index shows that global default rates are extremely low. This of course considerably reduces investment opportunities for managers of distressed funds. Since the default index is likely to increase gradually, distressed investment strategies may pay off later this year. We therefore feel it is perhaps a little too early to increase our exposure and are maintaining a neutral position for now. Mergers and acquisitions activity has no doubt slowed since last summer, judging from M&A volume indices. We are still seeing some large deals however this year, such as those involving Microsoft, BHP and Bank of America. And although on one side M&A fund managers will have a smaller investment universe in 2008, on the other side the average premium has also increased, which is a positive point. With equity markets still in turmoil, we prefer to adopt a neutral position, with a positive bias for the medium-term.
M&A volumes dropped
Source: Bloomberg-
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22 / 22
INVESTMENT STRATEGY FEBRUARY 2008
DISCLAIMER This document is issued by BNP Paribas Asset Management (BNP PAM), an investment manager registered with the "Autorite des Marches Financiers" in France. This document is produced for information only and does not constitute, and is not part of, an offer or solicitation to buy or to sell any securities.
The information and opinions contained in this document have been obtained from, amongst other things, public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate or complete and it should not be relied upon as such. Opinions included herein constitute the judgement of BNP PAM at the time specified and may be subject to change without notice, they are not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient and are not intended to provide the sole basis of evaluation of any strategy or instrument discussed herein. Any reference to past performance of any market or instrument should not be taken as an indication of future performance. No BNP Paribas Group company accepts any liability whatsoever for any loss arising, whether direct or indirect, from the use of any part of such information. Any BNP Paribas Group company may, to the extent permitted by law, have acted upon or used the information contained herein, or in the research or analysis on which it was based, before its publication. This document is for the use of the intended recipients only and may not be delivered or transmitted to any other person without the prior written consent of BNP PAM. Furthermore, any translation, adaptation or total or partial reproduction of this document, by any process whatsoever, in any country whatsoever, is prohibited unless BNPP AM has given its prior written consent.
