December-January 2012

INSIDE VIEW: An ‘existential crisis’

Woman_purseAs the economy enters a new phase of the debt-induced slump, Giordano Lombardo at Pioneer Investments looks at what could be done to return it to a normal level of activity. We are facing a new phase of the debt-induced crisis that began in 2007/2008 in which private debt issues have been transferred into public debt issues. This can not only jeopardise the very notion of “risk free investments”, but also introduces a form of market instability, which could be linked to political risk. This is the risk that world political leaders and authorities may neglect to deal with a phase which requires systemic and co-ordinated responses. Four years after the eruption of the crisis, global imbalances and private sector debt burdens remain very much centre stage. The main concern is regarding the capacity (or lack of it) of the post-crisis economy to return to a normal level of activity, because of the long lasting effects of system deleveraging. The euro area existential crisis
The euro area is at the epicentre of investors’ concerns and at this time could be seen as an “existential crisis”, in the sense that it threatens the very existence of the euro as a currency union. Possible outcomes range from progress on higher fiscal integration, to the disintegration of the currency union. A break-up would be very costly, however, while progress towards a fiscal integration seems challenging for the fragmented political agendas in the eurozone. European policymakers basically face two main challenges: what to do about continuing financial pressure in the periphery; and what to do about slowing growth across the region. The immediate challenge is to neutralise the financial crisis. The key is to stabilise an undercapitalised eurozone banking system and to ensure there is enough liquidity in solvent sovereigns and banks. Banks are currently the main mechanism for contagion, as we have seen from the correlation of performance of banks’ stocks and sovereign bonds. Our view is that progress could be made on the fiscal and institutional integration front, but at a slow pace, and with further episodes of market instability, linked to the political cycle of the main countries. The growth issue is more difficult to deal with, as the drag on growth from fiscal tightening will continue to linger, and could even increase. The only solution, in a currency union, would be for the countries with structural current account surpluses to finance their counterpart deficits, but there is a little consensus on this among the different countries. The US recession debate
Turning to the United States, the main concern is economic growth and not immediate fiscal crisis. The need to create employment in an extensive deleveraging and liquidity trap is of the utmost importance. Our view is that the US can avoid another recession, while Europe will find this more difficult. But once again, it is the political picture that we need to monitor. The US political debate has to shift from ideology – the size and role of government – to practical solutions on how to lighten the household debt load and sustain aggregate demand, promoting employment in the short term. Will emerging markets save the world?
There is widespread consensus that global economic growth and prosperity in the next few years will be experienced mainly in emerging markets. Their growth will benefit from easier global monetary policy, in addition to a productivity boost resulting from low debt levels and benign demographics. It is a view to which we subscribe, but with a caveat; emerging markets will face the political challenge of restructuring their growth model, relying less on artificially depressed currencies and promoting higher internal demand based on consumption. Opportunities and challenges for investors
So, what can we do as investors to deal with a world characterised by deleveraging, higher public debt burdens, lack of effectiveness of policy instruments and, above all, intractable political risk? The obvious consequence of a deleveraging, low-growth world is that most asset classes will carry very low yields, often close to zero. We expect a lasting and sustained demand for higher yielding securities where investors can harvest higher returns coming either from beta sources: lower quality credit, emerging market risk premia, high dividend risk premia; or from alpha sources, selecting managers who can demonstrably deliver absolute return. As investors with a value tilt, we intend to use market corrections to select higher yielding bonds, and high dividend stocks, and use tactical asset allocation to rotate into cheap assets, such as credit. It is conceivable that emerging markets will be rerated relative to developed markets in the long term, thanks to the structural economic progress of these countries (and the increasing issues of developed ones). Nevertheless, a robust value-oriented approach must be applied to these investments, too, as a pure “growth” approach based on long term perspectives will not be sufficient anymore.  The new environment poses significant challenges with regards to managing risk. The very concept of a risk-free asset class, one of the basic tenets of modern portfolio theory, is put under discussion. It is quite possible that we should adapt to an investing world without a risk-free rate at all. Investors should try to decide among the various potential risks, the ones they want to manage, or hedge. It is not possible to insure portfolios from every risk. For example, both a deflationary scenario and an inflationary one seem equally plausible, given the economic environment we have seen, and we should decide which one to hedge. Investors, therefore, need to be flexible and adapt their approach over time. We also should revisit our tool kit to manage risk and protect portfolios as market behaviour tends to be more erratic than in the past. The role of traditional diversification should be questioned due to massive shifts in correlations, especially in periods of market turmoil. Once again, a flexible approach that takes into consideration the time-varying nature of correlations should be considered. Another example of a concept to rethink is the identification of risk with market volatility. Not only elements of risks, such as excessive leverage or illiquidity, but also the concept of risk as volatility, which ignores the difference between upside and downside market movements. Today, “tail risk” management is a fashionable trend among investors. Many questions arise: has the cost of “insurance policies” risen to the point that they become worthless? Is tail risk management generating the very same risk it is trying to protect investors from? ‘Value’ and ‘macro’
A final thought on the “value” approach in the current investment environment. One might maintain that the emphasis on macro and political risks is opposed to an approach based on sound fundamental valuations. We do not agree with this view. We believe that any investment decisions, whether about the active selection of the assets or securities to invest in, or about the cost of hedging and protection, should always have an anchor on fundamental valuation. An expensive asset can give very disappointing outcomes in terms of future loss, but an expensive hedge can be detrimental to the long run returns of the strategy. We believe that to reconcile these two investment approaches, “value” and “macro”, will be key to survive and succeed in the new risky and “political” world ahead of us. Giordano Lombardo is group chief investment officer at Pioneer Investments ©2011 funds europe

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