With the cash yield basically at zero in the US, Europe and Japan it is difficult to answer the question why one should invest in US Dollars or any other Western Hemisphere cash at present. However, the return of capital as opposed to return on capital may be the prevailing environment leading into Q4, as the European crisis threatens growth and adds to volatility. When all correlations move to one, holding US dollars is the safest place to be. However, Emerging Market (EM) cash rates are relatively high at 5% + yields and their government balance sheets remain strong. Recent weakness in these EM currencies has created a buying opportunity for us, as this is one of our favoured asset classes. Momentum will return once currency volatility settles down. This short term weakness in EM currencies has created a particular buying opportunity in South East Asian and Latin American deposits.
Global Fixed Interest
As discussed before, US Government bonds, European Bunds or UK Gilts are to be avoided at current yield levels, on a 30 year view. However, in the short term, Treasuries are a safe haven from volatility and further short term gains cannot be discounted. In our view the risk reward has run its course in this asset class and we have now moved underweight with the exception of EM bonds, which we believe are in a bull trend, not a bubble. They remain one of our high conviction positions. Currency volatility has made these local market EM bonds more attractive, now that we are at the bottom of the price range.
An impressive arbitrage has opened up in the developed world commercial property market, particularly in London listed property. A 20% spread between the physical commercial property IPD index and the UK listed blue chip property REIT (Real Estate Investment Trusts) index has materialised over recent weeks, due to equities having sold off before the softening of the physical market. Asian growth remains intact and as such we are still overweight Asian commercial property, both physical and REITs. Singapore and Hong Kong are a risk from a residential perspective, but commercial rental growth appears solid in the region. Global Listed Property is now trading at an average yield of 5.45% p.a. Japan residential is an interesting sector which we are currently investigating. Special Situations in Europe abound, with big discounts to NAV with one of our largest holdings, Terra Catalyst, taking advance of the opportunities in this sector.
Valuations are back to 20 year averages but are still not cheap from a normalised earnings basis or 1930’s/1970’s valuation levels. Developed Markets (DM’s) were better value at the start of the year than EMs, but this gap is narrowing due to market performance and foreign exchange (FX) revaluation in recent months. Large Cap high dividend companies have solid balance sheets, but their earnings are the concern. The odds of a global recession are increasing each week but this is not currently priced into equity values and we feel it best to wait for Greece to finally admit bankruptcy, or for some other similar market panic to take prices closer to 1,000 on S&P500. Remember, if one must panic, it is best to panic first and to avoid European equities at all costs. Within global sectors, we still favour Technology as clear winners and losers makes the sector countercyclical. Re Insurance is trading at 0.8 times book and global large cap value is very attractive from a free cash flow and dividend yield perspective. To buy on valuation would mean relying on US and European politicians making the right decisions together with the non-materialisation of a slow-down in China, both of which remain uncertain to say the least.
Alternative Strategies had a difficult quarter. The Dow Jones Credit Suisse Core Hedge Fund Index finished down -4.23% in September, bringing year-to-date performance to -7.84%. In the Event Driven space, losses mainly stemmed from relatively concentrated long equity positions, related to special situations. Global Macro managers declined following sharp reversals in precious metals, such as gold which posted its worst monthly loss since 1983. Volatility of emerging market currencies/bonds has also added to the trend following funds underperformance. Compared to the year-to-date drop of -15.36% for the Dow Jones Global Index, hedge funds have provided some level of relative capital preservation to date this year; however, all strategies appear to be feeling the pain with market uncertainty at an all time high. The volatility and seesaw nature of equity markets since the initial early August collapse in risk assets is not helping, but unlike 2008 the liquidity and credit issues are not in evidence this time.
As we have learnt from Nassim Nicholas Taleb’s impressive book - The Black Swan: The Impact of the Highly Improbable risk models cannot guard against the occurrence of highly unlikely, extreme events. His example was the discovery of black swans by Europeans in Australia, when all previous experience suggested that swans could only be white. The improbable Improbable had transpired. Perhaps the Europeans can cause another unlikely event at the Rugby World Cup Final this year?
The past Quarter has been very difficult for risk assets, but we have not encountered any Black Swan events yet. Most asset classes were negative but, interestingly, not all were correlated or weak at the same moment in time. Problems in Greece and the sovereign debt crisis are well known and priced into European risk assets although perhaps not the Euro just yet. An improbable Unknown would be an actual sovereign default or problems within the ECB itself. The US recession is priced into risk assets, on a 50% probability basis, but a further Black Swan event such as an actual recession or social unrest is not. Finally, China is one big unknown Unknown.
To buy global equities at the start of this Quarter on the basis of good value requires a bet on two things: firstly the ability of European and US politicians to organise a booze-up in a brewery and secondly fears around a Chinese slowdown proving unfounded. Is this a finely balanced bet or a Black Swan event?