While much has transpired in financial markets over the past quarter, much remains unclear about the road ahead. Bond yield melt down, equity trap door decline, financial repression, sovereign debt infection, all have become front-page news. Does this mean all is in the price and one can go bargain hunting? Not so fast remains the counsel, not so fast.
Three big risks remain. First, the shape and timing of the EU sovereign debt end game. Second, the effect of sharply lower OECD growth on US corporate earnings. Third, the rising risk of stagflation in the emerging economies.
As we enter Q4, investors are bloodied and bowed, exhausted by the stress of market volatility, the strain of navigating the political risk minefield and the fear of another 2008. Political risk: difficult to model, hard to guard against or profit from, is most challenging. The resultant combination of high risk and low return has led many to the sidelines, reducing liquidity and increasing volatility. Stock correlations are at all time highs, commodities, including gold, have sold off heavily, bond & dollar bears have taken early hibernation; few investors are walking tall post Q3 results.
Investors' coping mechanisms should include the following steps. First, investors must lift up their heads and look beyond the day-to-day volatility. Second, play defense by ensuring portfolios remain bullet proof against the three risks noted above. Third, prepare to go on the offensive by focusing on what 2012 is likely to bring... namely, the global search for yield.
As volatility ebbs, as it must at some point, the investment community will note that 2012 is around the corner and begin to think about how to position for the new year. Today, thanks to Operation Twist, US Treasuries join UK Gilts, German Bunds and JGBs in yielding under 3% across the yield curve. This environment creates huge challenges for vast pools of money, including the pensions of many global equity index constituents, who have built into their return and payout calculations average per annum returns of 5-7%. Given equity market volatility, it seems likely that investors will spend the next year scouring the globe for risk-adjusted yields.
Many of these pension calculations were done when cash yielded 2-3%, Government bonds yielded 4-5%, and one could look forward to 6-7% pa returns in the equity markets. As the 4th quarter begins, global equities are down over 15% ytd, cash yields zero while five year UST yield 90 basis points, a return/duration mix which challenges investors and savers alike as financial repression and negative real yields do their work.
Cash may be fine through year-end as capital preservation trumps appreciation but as the year turns, zero cash yields and capital preservation will give way, to a degree, to a search for capital appreciation. Historically low new money yields suggests the challenge will be arduous.
Not only are new money yields very low but risks remain high. How are these risks likely to play out? In the case of the EU periphery, markets & policy makers alike seem to be preparing for an orderly Greek default. The hope seems to be to manage such a default, have the banks survive it and allow the policy makers to say see, its all ok.
This may work for a quick trade but not for an investment as the price of the EU's delay and react strategy has been the passage of time, time during which the infection has spread, from the periphery to the core, with Italy now squarely in the line of fire. Before all is said and done, it is likely to spread to Germany too. Of course, anyone long the DAX might say it already has.
Let us ignore the volatility & go back to first principles: What does Germany, the EU's main actor, seek? Germany wants to remain an export powerhouse which requires a weak Euro. If Greece and others were to exit the Eurozone, the Euro would most likely trade much stronger - some have speculated over 2 to the USD - no prize for guessing what that would do to Germany's exports which are responsible for close to 50% of GDP.
Germany appears to have two choices: a strong Euro with negative economic effects or higher bund yields as markets reprice the bund as a hybrid German/EU credit. As such, it should yield closer to 4% or so from its current 1.9% yield. A 4% ten year Bund would seem much more appealing to Germany than a Euro that trades 2:1 to the USD. A corollary to option two is likely to be a weaker euro, providing further support for that being the eventual choice. Long dollar versus Euro in the interim while at some point being short the bunds could offer good returns.
What about risk #2, the earnings outlook? Much has been written about the appealing valuations on offer around the globe. However, cheap valuation seldom marks a bottom and 2012 earnings estimates are very suspect. While GDP estimates have been cut and many private investors expect earnings growth to go negative in 2012, current consensus is for between 12 - 14% earnings growth for global equities, numbers that seem highly unlikely to be met. It is hard to see equities rallying strongly while consensus earnings numbers decline sharply. High dividend yielding stocks could get caught up in this undertow.
The third risk factor is the potential for the emerging economies to become mired in a stagflationary environment. These economies represent the world's sole source of sustainable end demand. An OECD growth slowdown/recession will impact exports while the past year's domestic rate tightening cycle will slow internal demand. The IMF forecasts emerging economies will have 6% GDP growth and inflation in 2012, both down slightly on 2011 forecasts. Recent currency & copper price weakness raises stagflation risks and suggests limited room for further stimulus.
Investors might consider a three-step process to investing in this environment. First assess the risk - reward profile of their portfolios in light of the risks discussed above. Second, identify the opportunity set for new money. Third, and perhaps most challenging, determine the time frame to invest. We have discussed the risk profile, what about the opportunity set?
In the global search for yield, four principal areas of opportunity stand out. First is USD denominated Emerging Market debt. While local currency EM debt became a crowded trade (currently being unwound), the same is not the case for USD debt. Investors access better sovereign balance sheets at a significant yield pick up over UST. Second, infrastructure investment is likely to grow significantly in both the OECD and EM while offering private capital a rare combination of duration and yield.
Two other opportunities include US corporate spread product, both high yield and floating rate bank loans, which have been sold off heavily and yet offer attractive yield and exposure to the US corporate sector, the most fundamentally sound segment of the market. Given the outlook for a strong dollar, weak growth and EM stagflation, spread product looks more appealing than straight equity. Finally, the long end of the UST curve remains attractive with the Fed committed to be a significant buyer of new paper thru June while the economic, political and investor backdrop remains favorable. The 30yr UST bond could retest its 2008 yield low of 2.5%.
How should investors assess timing? There are two components to this issue. First, correctly timing the EU debt resolution. While markets have repriced and politicians are saying more of the right things, the many votes to be taken in the next few months present short-term risk. In addition, there is a very large wave of debt maturing at both the sovereign and bank level next spring, suggesting that the lender of last resort needed to truly stabilize Europe will appear then. This may present the best time to invest. The second component is the wave of cash that is likely to be invested by cash rich and yield hungry investors in the months ahead. Ideally one would like to be in front of that wave. Determining the intersection of these two components will represent the art of investing in 2012.