August 2008

RECESSION: The Cash Call

Investors have rushed into the safe haven of cash against the backdrop of economic uncertainty. But as recession edges closer, there are a few who are prepared to invest in other assets, writes Nick Fitzpatrick Those who predict the US will enter recession may have to wait a little longer before they can relax in the satisfaction of being right. At least two consecutive quarters of rising prices, coupled with a slowdown in real growth, are needed for authorities such as America’s National Bureau of Economic Research to declare a technical recession.

So far the US has got only half way there, for though the first quarter of 2008 witnessed a sharp slowdown, tax breaks led consumers to boost the economy in the second quarter, averting a recession.

Just as the US has managed to stay recession-proof this year, one of its largest listed fund managers, BlackRock, has also performed well. The company recently reported that in Q2 assets under management increased 5% over Q1 to $1.428 trillion. With net new business totaling $63.2bn during the quarter, anyone might think the credit crisis was over.

But uncertainty does persist. Inflation continues – though opinions vary about when it will level off – and there is still nervousness in the housing market. Yet a full-blown recession proves elusive.

For other industries, dealing with a recession is a relatively well-rehearsed exercise. Certain food manufacturers, for example, can bring down prices by lacing their ready meals with cheaper ingredients. But from a strategic perspective, long-only equity and bond managers must just sit tight and watch assets leak from their portfolios as investors seek a safe haven in cash, and then watch further as markets erode what’s left, hoping the experience will be short.

Moreover, for a fund manager it is a case of waiting for those flows into cash to reverse back towards riskier assets. In the last six recessions cash outperformed stocks until halfway through the cycle. Therefore, the ‘cash call’ is the biggest call a fund manager can make during a recession. It is notable, then, that Larry Fink, BlackRock chief executive, has already observed clients moving away from cash.

Looking elsewhere
Of the $63bn of new business that BlackRock saw in Q2, $50.4bn and $9.3bn of net new business from US and international institutions respectively went into riskier long-dated products, while BlackRock saw net outflows from cash.

“We are seeing some clients of ours starting to look for other opportunities… We are beginning to see clients start utilising their cash and they are looking to invest in more risky assets, whether distressed debt, distressed mortgages, and in some cases equities,” he told analysts. Additionally corporate bosses are looking to buy extra shares in their companies and invest in plant, he said.

So is this the start of a rebound that will avert a recession? Fink stops short of making that call.

“I think for the global economy it would be a good thing if we start seeing fear reduced. I’m not suggesting that we are seeing fear reduced, but I am suggesting in some cases we are starting to see clients looking to reassess their overall cash positions, looking to reassess how to use their cash…”

Nevertheless, 55-year-old Fink says the headwinds in the markets are as strong as he’s ever known them, but he believes fear and inflation will abate if stability can be brought to consumer confidence. To do this, the US government must take action on the real-estate market – it’s not just a private-sector responsibility, he says.

As well as relief in the housing market, Bob Doll, BlackRock’s chief investment officer, says the two other conditions that are needed to change investors’ risk perceptions and herald a return of the equity bull market are a significant fall in oil prices and a noticeable decline in headline inflation.

“We have been arguing for some time that oil prices were due for a correction. Last week’s decline [the week beginning July 14] could mark the beginning of this correction, particularly considering that demand pressures for oil in the developed world have receded somewhat in recent months,” Doll says.

Further, Doll expects headline inflation rates to fall over the next few months, particularly if there is some additional relief in energy prices. But he notes that tensions between a slowing economy and inflation pressures have continued despite recent economic data that has pointed to a weak, but still growing, US economy.

Meanwhile, inflation figures continue to be skewed by food and energy. Analysts at Citi note that core inflation rates (excluding food and energy) remain more subdued in most countries. For example, Eurozone core rates were at 2.5% in May, versus headline of 3.7%.

Let’s get physical
All this muddies the waters for those who are trying to predict a recession, let alone for those predicting when to move out of cash. Yet other managers, like some of BlackRock’s clients, think the sector is already not the best place to be.

Christian Gattiker-Ericsson, head of research at Julius Baer, says he is more interested in real assets – those with a physical, rather than a financial, worth.

“Real assets are attractive due to the reflation efforts of central banks. To stimulate the economy the Federal Reserve runs negative real yields, making cash holdings unattractive in real terms. For example, if there is a 2% money market rate, but the inflation rate is 4%, on cash you lose 2% on a real basis. Hence, paper money loses its value so you want real assets like gold.”

He adds: “US and Asian real estate and direct and indirect commodities are therefore worth holding. An exception is industrial metals, which follow the industrial production cycle and tend to lose value during economic weakness. Oil-related assets are also a good hedge against political risks.”

In terms of financial assets, Julius Baer recommends stock sectors such as energy and commodity companies, consumer staples and healthcare, while being underweight in financial and consumer discretionary stocks.

Based in Zurich, Gattiker-Ericsson points out that many people in Switzerland own financial and pharmaceutical stocks and that these are not favoured by a reflationary environment.

“After all, these stocks were beneficiaries of falling inflation rates in the 1980s and 1990s. Financials in general and banks in particular benefit from falling inflation rates as their financial assets are less devalued in real terms than expected.”

In broader Europe, he adds, there is a natural bias against commodities. In index terms, in the Euro Stoxx 50, for example, there is hardly any commodity or energy-related stocks, with the possible exception of Total SA and ArcelorMittal.

Gattiker-Ericsson notes there are certain hedge fund strategies – such as global macro or those investing in commodities and the more illiquid assets like real estate – that should sit well in a portfolio at the moment. But he adds that the higher cost of leverage could pose problems. In this crisis a lot of hedge funds and market neutral investors have been hit because they ran serious credit risk and had to de-leverage or unwind their positions in a very adverse environment.

Gattiker-Ericsson stresses that recession is not a major scenario for Julius Baer and portfolio alterations would not be made purely due to a recession. But like other professional investors, he has a view about the likelihood of recession.

Reassessing recession
A recession in the US is still possible and is even more likely in Europe, he feels. It will probably be a heavy slowdown compared to 2007 but not as broad, bad or deep as 1994.

“We think there will be a mild recession in the US even though consumption has most likely held up reasonably well in Q2. The US government put together a fiscal stimulus package and Americans used some of this tax relief for consumption.”

This support is only temporary and high energy prices, tighter credit conditions and a deepening housing recession will all be taking their toll on the consumers, says Gattiker-Ericsson.

He expects European economies to weaken over the coming quarters, but this is not expected to lead to a full-blown recession.

“The relative strength of Germany, which accented the divide within the Eurozone, is waning, slowing down growth momentum of other member-economies. Spain, Italy, Portugal and Ireland are clearly slipping into recession,” Gattiker-Ericsson says.

“You have to note that defining a recession is often a question of semantics. At the end of the year the National Bureau of Economic Research will declare whether or not there was a recession [in the US], and sometimes a recession may be redefined as a non-recession further down the line.

“The definition of recession is therefore somewhat esoteric.” ©  2008 funds europe

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