1.
Prevailing Winds Paul Marson, Chief Investment Officer, Private Banking May 2011, Moscow
2.
<ul><li>“ Only buy something that you’d be perfectly happy to hold if the market shut down for ten years” </li></ul><ul><li>Warren Buffett </li></ul>
3.
De-leveraging and Global Imbalances.. <ul><li>Cumulative Emerging Surpluses = NET Asset accumulation with corresponding, and unsustainable, NET liability accumulation in the West... </li></ul><ul><li>De-leveraging implies a reduction in the Western Deficit and a corresponding decline in the Emerging Surplus... </li></ul>Source: Datastream, LODH Calculation
4.
US De-leveraging….incomplete <ul><li>The extent of excessive leverage growth and the overhang in debt can be seen in the 5 year rolling change in Debt versus Private Gross Domestic investment...the Private Capital Stock supports aggregate National Credit Market Debt </li></ul><ul><li>Total US Credit Market Debt outstanding tracked Private Gross Investment in much of the post-war period , diverging in the late 1980’s S&L bubble and the 2006/7 Housing Bubble…there is still too much debt for the private capital stock to support </li></ul>Source: Datastream, LODH Calculation
5.
Global RE-leveraging….!! <ul><li>Looked at on a rolling 5 year cycle, to eliminate some of the annual volatility, Global Securities debt growth has outpaced Nominal GDP persistently over the last decade, with the exception of the period up to 2008…no hint of de-leveraging here… </li></ul><ul><li>The total sum of Global Domestic and International Debt Securities outstanding increased by $20 trillion in the 3 years from the end of 2007! The ratio of Debt Securities / Global GDP increased from 140% to 160%... </li></ul>Source: BIS, LODH Calculation
6.
OECD Lead Indicators.... <ul><li>Developed Country OECD lead indices also point to moderating growth, after a government debt fuelled/inventory driven cyclical rebound... </li></ul><ul><li>Lead Indicators in the Emerging Markets point to slower growth.. </li></ul>Source: Datastream, LODH Calculation
7.
Inflation and Deflation.... <ul><li>China inflating [internal supply very inelastic versus external supply]...money growth slowing. Inflation at 5.3%, 2 year high, Food Inflation at 11.5%...Aggressive tightening necessary…. much slower growth ahead as credit availability evaporates </li></ul><ul><li>On balance, over half of US and Japanese core inflation sub-components are deflating…no risk of deflation in the UK and Eurozone </li></ul>Source: Datastream, Bloomberg, LODH Calculation
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US – Rolling Sectoral Deficits and MORE Debt...? <ul><li>Valuation cycles at the extreme in the last decade, and the unquestionably poor performance of the US market, have been driven by rolling deficits and ever increasing levels of aggregate credit market debt…..the end of ALL debt cycles [public or private] necessitates asset price adjustment… </li></ul><ul><li>A proxy Price / Sales ratio for the US market and, according to Warren Buffett, the single most important measure of valuation. Above 100% for one quarter between 1900-1995, now at 118%, in the 16 th percentile...miserable implied returns! </li></ul><ul><li>Driven by record $53trn total US credit market debt.. </li></ul>Source: Datastream, LODH Calculation
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US extreme over-valuation…again.. <ul><li>At the current level of valuation, implied annualized REAL returns are barely 1% over the next decade: there is no margin of safety of note implicit in US market valuation…the market prices US equities akin to a “risk-free” asset …. </li></ul><ul><li>The US market is valued at 26.5 * trailing ten year average earnings: if we strip away the tech bubble in 1999/2000 and housing bubble in 2006/7, this is the highest level of valuation since 1929. Current Valuation is in the 10 th percentile since 1870 i.e. 90% of the time historically the market has been cheaper….. </li></ul>Source: Datastream, LODH Calculation
10.
US Risk Premium and Implied Returns.. <ul><li>The very poor level of implied returns is reflected in a wafer thin implied equity risk premium...barely 0.7%, the 13 th percentile over 110 years, if valuations revert to the median level. A low level of implied return plus a low margin of safety should be a warning to investors … </li></ul><ul><li>The range of implied returns, from current valuation levels, is between -4.7% to +3.1% annualized, assuming median reversion or a historical worst case valuation multiple….implied returns are very poor by historical standards…. </li></ul>Source: Datastream, LODH Calculation
11.
US Drawdown risk…where the US goes… <ul><li>When ranked according to US return decile, NON US nominal annualized returns decline in predictable fashion as US returns worsen: at the lower end of the US return distribution, NON US returns are negative… where the US market goes, global markets follow .. </li></ul><ul><li>The maximum annualized drawdown for the investment holding period increases as the implied equity risk premium declines! ….in the first and second deciles the drawdown exceeds the implied return very substantially...we are currently in the 13 th percentile </li></ul>Source: Datastream, LODH Calculation
12.
US Equities – High Profit Margins = Poor Prospects <ul><li>The ability of current Margins to predict Profit Growth improves further at the 5 year horizon: over the next 5 years, current elevated margins imply negative nominal net profit growth ….margins DO mean revert </li></ul><ul><li>Current Profit Margins are a very good predictor of future Profit Growth , at a 3 year horizon: high margins = low implied profit growth [and vice-versa]. An 8.5% net non-financial sector margin implies negative profit growth .. </li></ul>Source: Datastream, LODH Calculation
13.
US Equities – Corporate De-Leveraging…Really? <ul><li>Companies have record cash ASSETS, but they correspond to record Credit Market Debt LIABILITIES. Moreover, cash holdings, as a percentage of financial assets, are at the highest level since 1979, but remain low by historical standards.. </li></ul><ul><li>US Non Farm Non Financial Corporate Businesses have $7.4 trn of Credit Market Debt, a record amount... they have $1.5 trn of cash assets [deposits, money funds, repos], a record amount.. </li></ul>Source: Datastream, LODH Calculation
14.
US Equities – the definition of Cheap… <ul><li>Besides, even if valuation were historically cheap on this comparable basis… the relationship to forward realized returns is extremely weak.. </li></ul><ul><li>The S&P500 is valued at 13.5* one-year forward Operating Earnings: the long run median for THAT ratio is 13* [it should not be compared to historical REPORTED earnings valuation multiples]...a 15* multiple is the ceiling in the 1960s, 1987, 1991, 2007 and in 2009.. </li></ul>Source: Datastream, LODH Calculation
15.
More than just Growth….…the US case <ul><li>Even the CHANGE in the annual GDP Growth rate forecast in any 6 month period is negatively correlated with US equity returns over the subsequent 6 month period: actual and expected GDP growth are NOT positively correlated with realized market returns…. </li></ul><ul><li>The relationship between expected US GDP Growth over the next year and subsequent, realized, Equity Returns is negative! When Growth expectations are strong, it is usually the precursor to lower returns. Actual Growth and Returns are negatively correlated cross sectionally across markets…. </li></ul>Source: Datastream, LODH Calculation
16.
Quantitative Easing II / III / IV …who cares? <ul><li>Increases in the supply of money induce a near perfect offsetting reduction in the velocity of circulation of money: if velocity declines proportionally with the rise in money supply, nominal income is unaffected.. </li></ul><ul><li>Money Supply * Velocity of Circulation of Money = the Price Level * Income [MV=PY]. As rates converge to zero, the velocity of circulation of money collapses…monetary policy pushes on a piece of string at low rate levels… </li></ul>Source: Datastream, LODH Calculation
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Can Equity Price Inflation lift the US Economy ..? <ul><li>The decline in velocity in Japan has also been proportional to monetary growth, explaining the ineffectiveness of Japanese monetary policy measures since the early 1990s..….. </li></ul><ul><li>Real Equity Market Returns have an extremely weak and insignificant impact on forward Real US GDP growth…[+1% S&P = +0.032% GDP one year ahead]…smaller than the error term in the National Accounts </li></ul>Source: Datastream, LODH Calculation
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The difficulty in unwinding QE2! <ul><li>Very low rates imply a very high level of “Liquidity Preference” [ 1 / V = M / PY ]..the relationship is non linear i.e. huge monetary withdrawals are consistent, in the first instance, with a modest rise in rates. Policy reversal must be highly front-loaded.. </li></ul><ul><li>Money Supply * Velocity of Circulation of Money = the Price Level * Income [MV=PY]. As rates converge to zero, the velocity of circulation of money collapses…monetary policy pushes on a piece of string at low rate levels… </li></ul>Source: Datastream, LODH Calculation
19.
Japan...preparing for “X-day”… <ul><li>The household savings rate has fallen to zero in the last 30 years: a structural decline in the level of the population, together with a rising dependency ratio [retirees / workers] implies no increase in net domestic saving levels…in fact, the contrary is to be expected.. </li></ul><ul><li>Net Savings exceeded the budget deficit over the last 20 years : going forward, that reverses and Japan will have to rely on foreign financing for the budget deficit, as net domestic saving levels for short of the required level… </li></ul>Source: OECD, Datastream, National Data Sources, LODH Calculation
20.
Population decline and Saving behaviour..… <ul><li>Retirees have a substantially negative savings rate: more retirees relative to workers means a lower level of national savings and a structural inability to finance domestically…Japan is, finally, falling dependent on foreign capital.. </li></ul><ul><li>The “dependency ratio” increases steadily as the number of retirees increases and the working age population share diminishes : a structurally increasing burden on a shrinking workforce… </li></ul>Source: NIPSSR, LODH Calculation
21.
The scale of Japanese Fiscal irresponsibility....… <ul><li>Debt service absorbs 21% of Government Revenue: every 100bp increase in the Japanese Government Weighted Average Cost of Capital is estimated to divert 25% of Revenue to debt service !! </li></ul><ul><li>The ratio of Government Debt / Tax Revenue is a key sustainability metric: Japan is far beyond any other country and extremely vulnerable to a rise in financing costs…420% is a historical “tipping point” [Reinhart & Rogoff (2008)] </li></ul>Source: Moodys
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Global Deficits : Sectoral Balances <ul><li>Current Account countries tend to be burdened with higher net interest servicing costs…especially where current account deficits particularly reflect public sector deficits. </li></ul><ul><li>The Current Account Balance is the sum of the Government and Private Financial Balances [Gross Saving – Gross Investment]...Only the Swiss and Norwegians have a “double surplus”… </li></ul>Source: Datastream, LODH Calculation, See Wynne Godley « Debt and Lending », 2006/4
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Simple Notes on Fiscal Policy, Debt and Deficits <ul><li>Real Debt Growth = Real Primary Deficit / Real Debt (previous period) + Real Interest Payments / Real Debt (previous period) </li></ul><ul><li>Which is equivalent to , </li></ul><ul><li>Real Debt Growth = Real Primary Deficit / Real Debt (previous period ) + Effective Interest Rate on Real Debt </li></ul><ul><li>Given this , </li></ul><ul><li>The Debt / GDP ratio increases with the ratio of the Primary Deficit / GDP and the difference between the Real Effective Interest Rate and the Real GDP Growth Rate, formally </li></ul><ul><li>Change in Debt / GDP = Primary Deficit / GDP + ( Interest Rate – Growth Rate ) * Debt / GDP </li></ul>See, for example, Craig Burnside « Fiscal Sustainability in Theory and Practise »
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Notes on Fiscal Sustainability The Arithmetic of the Sustainability of Government Debt is simple and irrevocable: Define the following variables, d = net Debt / GDP ratio at the start point [ch d = the change in the ratio over one period ] s = the Primary Budget Balance as a % of GDP [the non interest inclusive balance] g = the growth rate of Real GDP r = the Real interest rate on the Outstanding stock of Public Debt Then, ch d = -s + [ (r – g ) / ( 1 + g ) ] * d So, to keep the Government Debt / GDP ratio constant, the Primary Surplus as a percentage of GDP must be, s = [ ( r – g ) / ( 1 + g ) ] * d
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Notes on Fiscal Solvency The Arithmetic of the Solvency of a Sovereign Borrower is similarly easy to derive: Define the following variables, D = net Debt / GDP ratio at the start point S = the expected long run average Primary Budget Balance as a % of GDP G = the expected long run average growth rate of Real GDP R = the expected long run average / equilibrium Real interest rate on the Outstanding stock of Public Debt Then, any sustainable policy must satisfy the constraint that the outstanding debt cannot exceed the discounted present value of the current and future primary balance, S > or equals [ (R – G ) / ( 1 + G ) ] * D The minimum value of the Primary Surplus [S min] as a percentage of GDP is S min = [ ( R – G ) / ( 1 + G ) ] * D
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Fiscal Inference Therefore, if Real Interest Rate on Debt [ R ] > Long Run Trend Real GDP Growth [ G ] Then Any country with a positive outstanding Government Debt MUST run future Primary Budget Surpluses For example, a country with a 100% net Debt / GDP ratio, trend Real GDP growth of 3% and an expected average Real interest rate on the Stock of Government Debt of 4% will have to run, on average, future Primary Surpluses equal to 1% of GDP. If the Primary Deficit were, say 6% of GDP, then it would have to raise taxes / cut Public Spending by the equivalent of 7% of GDP on average in the future [i.e. permanently]
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Fundamental Fiscal Data Source: OECD, Datastream, LODH calculations, See Willem Buiter « Measuring Fiscal Sustainability », University of Cambridge, 1995 So, for the USA, assuming trend Real GDP growth at 2.5% and a Real Interest Rate of 3.0% on the outstanding stock of Government Debt and a net Debt / GDP ratio of 68%, a primary surplus of 0.3% of GDP is necessary [1% from estimated 2011 debt levels], requiring a near 8% of GDP swing in the Primary Balance…… draconian policy tightening [spending cuts and / or tax increases] required, under very conservative assumptions
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US Fiscal Stability Scenarios Source: Datastream, LODH Calculation
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Japanese Fiscal Stability Scenarios Source: Datastream, LODH Calculation
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UK Fiscal Stability Scenarios Source: Datastream, LODH Calculation
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What needs to be done?.... Rather a Lot !! Source: OECD, Datastream, LODH Calculation Given 2010 starting Net Debt ratios, and assuming historical trend Real GDP Growth and Real Interest Rates , the necessary policy tightening is 4.5% -5.5 % in Spain and Portugal, 6.5% in Ireland and in excess of 7% in Japan and the USA. At TREND GDP Growth and CURRENT Real Yields, the necessary adjustment is 9.7% of GDP in Ireland, 8.8% in Greece and 7.8% in Portugal…larger with inevitably slower Real GDP growth! Default / Restructuring is both inevitable and unavoidable in those Countries .
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Early Warning Signs Source: IMF The IMF recently published a “Fiscal Stress Index” and a “Fiscal Vulnerability Index” (see “Measuring Fiscal Vulnerability and Fiscal Stress: A Proposed Set of Indicators”, E Baldacci, J McHugh & I Petrova, IMF WP / 11 / 94, April 2011): the variables monitored are , 10 Year average Interest Rate – GDP Growth Rate gap….”solvency” General Government Gross / Net debt….”debt burden” Cyclically Adjusted Primary Balance….”correction for the cycle” Total Fertility Rate….”population ageing” Dependency Ratio Projections….”implied burden of ageing population” Projected Pension and Health Expenditures….”social burden” Current Gross Financing Needs….”rollover and new borrowing requirement” Short Term Debt / Total Debt Outstanding….”vulnerability to rollover risk” Debt Denominated in Foreign Currency….”exposure to Foreign Exchange Risk” Proportion of Debt held by Non Residents….”non home bias risk” Weighted Average Debt Maturity….”vulnerability to market sentiment” Short Term External Debt….”drain, for EM countries, on FX resources”
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Implications of Increased Government Leverage <ul><li>Looking at just the post-War period, the same relationship appears to hold: achievable Real GDP Growth in the Advanced Economies declines materially (with obvious implications for sustainability and solvency) at debt ratios beyond the 90% threshold… </li></ul><ul><li>Reinhart & Rogoff [2007] illustrate a relationship [causality?] between Government Leverage and achievable Real GDP Growth rates. In the last 200 or so years, there appears to be a “break” in achievable GDP growth at Debt ratios above 90%.. </li></ul>Source:Reinhart & Rogoff (2008)
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How to Tackle the Debt/Deficit problem? <ul><li>Welfare Systems are under threat, and the evidence suggests those that are least effective will bear the brunt of adjustment ..without severe consequences! Greece, Spain [and Portugal] have particularly expensive and ineffective systems… </li></ul><ul><li>Fiscal Policy tightening implemented through cuts in Spending are far more likely to succeed [reduce the cyclically adjusted primary balance by at least 1.5% points of GDP] than are policies focussed upon increasing Revenue… </li></ul>Source: Alberto Alesina « Fiscal Adjustments: Lessons from Recent History », Harvard, April 2010, Eurostat 2003
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Exposure to the Fiscal Problem Countries <ul><li>US Banks are particularly exposed in Japan, with European banks having $3.4 trn in exposure to the US… </li></ul><ul><li>German and French banks are most exposed to the PIGS bloc : they account for one-third of TOTAL foreign bank exposure. They have approximately $305bn in exposure to Portugal, Ireland and Greece alone (30% of the total), with Spain another $320bn (38% of the total)! </li></ul>Source: BIS, LODH Calculation
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Japanese Equity Valuation....cheap at last! <ul><li>This gives a range of implied annualized holding period returns from +5% to +14%, consistent with a substantial and positive implied equity risk premium , even under conditions where valuation multiples fall to record lows, for the first time in 40 years … </li></ul><ul><li>Japanese valuation is exceptionally low, by historical standards, in fact over half of listed Japanese companies trade at valuation below their book [or liquidation] value, balance sheet cash is one-third of the market cap [depresses RoE].. </li></ul>Source: Datastream, LODH Calculation
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Attractive European ex UK Equity Valuation....… <ul><li>This gives a range of implied annualized holding period returns from +3.5% to +10%, consistent with a substantial and positive implied equity risk premium, even under conditions where valuation multiples fall to record lows… </li></ul><ul><li>In contrast with the US market, Europe ex UK valuation levels remain depressed and attractive, still substantially below bubble-like levels.. </li></ul>Source: Datastream, LODH Calculation
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UK Equity Valuation....still undervalued <ul><li>This gives a range of implied annualized holding period returns from +5% to +11%, consistent with a substantial and positive implied equity risk premium , even under conditions where valuation multiples fall to record lows… </li></ul><ul><li>UK equity market valuation remains attractive, even after the marked rally from the 2009 low: at levels observed in the early 1980s.. </li></ul>Source: Datastream, LODH Calculation
41.
Emerging Markets...Imbalances <ul><li>Emerging Market Equity returns are modestly positively correlated with Western Advanced Country growth rates, but not significantly….. </li></ul><ul><li>Emerging Market growth is a function of the willingness of the West to leverage [increase it’s debt] and no more!...the growth differential between developing and emerging countries is a direct consequence of a widening developed country current account deficit.. </li></ul>Source: Datastream, LODH Calculation
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Emerging Markets...Imbalances and Equity valuation <ul><li>The “apparently” low valuation multiple versus forward earnings [which are always forecast to be strong in Emerging Markets!] has no ability to predict one year forward index returns….. </li></ul><ul><li>As the US Current Account deficit expanded, and the share of the BRIC surplus rose correspondingly, the valuation discount of Emerging Equities evaporated and moved into premium….Emerging Equity valuation reflects an unsustainable external balance position </li></ul>Source: Datastream, LODH Calculation
43.
Russian Equity Valuation … <ul><li>Assuming long run trend earnings per share growth, and a range of alternative terminal valuation multiples [trailing minimum, median and maximum], implied Russian Index returns are in the range -7% [assuming historically low valuation] to +8%….. </li></ul><ul><li>The Russian market is near equilibrium valuation at 6 * trailing peak reported earnings per share and 1.3 * book value.. </li></ul>Source: Datastream, LODH Calculation
44.
Russian Issues <ul><li>The challenges facing Russia are : </li></ul><ul><li>Inflation and Monetary Policy </li></ul><ul><li>Fiscal Policy and Reform e.g. pensions, health and welfare </li></ul><ul><li>Improving the “Investment Climate” with structural reform </li></ul><ul><li>Potential GDP growth with a declining population : Productivity </li></ul><ul><li>A “Rules Based” versus “Discretionary” policy environment </li></ul><ul><li>Banking Supervision </li></ul><ul><li>Avoiding the “Dutch Disease” </li></ul>
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Emerging Markets...more than just Growth.... <ul><li>From current valuation levels, implied returns are very modest in the BIC bloc: for example, in India, assuming peak eps growth, implied holding period returns lie in the range of just 0% to +7%..that provides a negligible implied risk premium. </li></ul><ul><li>Emerging Market Growth and Equity Returns are negatively correlated [insignificantly]……the Tortoise beats the Hare!...strong growth is NOT a positive for relative equity returns </li></ul>Source: Datastream, LODH Calculation, see P B Henry & P Kannan (2006) « Growth & Returns in Emerging Markets »
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Country and Sector preferences Rankings and change from previous month Neutral Positive Negative <ul><li>Turkey </li></ul><ul><li>Korea </li></ul><ul><li>Russia </li></ul><ul><li>South Africa </li></ul><ul><li>Mexico </li></ul><ul><li>Hong Kong </li></ul><ul><li>Taiwan </li></ul><ul><li>China </li></ul><ul><li>Brazil </li></ul><ul><li>India </li></ul>BRIC bias Neutral BRIC vs. other Emerging Non-BRIC bias Emerging Country Ranking Developed Country Ranking <ul><li>Italy </li></ul><ul><li>France </li></ul><ul><li>Germany </li></ul><ul><li>Japan </li></ul><ul><li>Spain </li></ul><ul><li>UK </li></ul><ul><li>Switzerland </li></ul><ul><li>US </li></ul><ul><li>Canada </li></ul><ul><li>Australia </li></ul>European bias Neutral Europe vs. US US bias <ul><li>Healthcare </li></ul><ul><li>Consumer Discretionary </li></ul><ul><li>Telecom </li></ul><ul><li>Consumer Staples </li></ul><ul><li>Energy </li></ul><ul><li>Industrials </li></ul><ul><li>Materials </li></ul><ul><li>Information Technology </li></ul><ul><li>Utilities </li></ul><ul><li>Financials </li></ul>Defensive bias Neutral Defensives vs. Cyclicals Cyclical bias Sector Ranking Source: Lombard Odier
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Consistent Yearly Out Performance (Fully Invested Strategy)
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Back Testing the Strategy (fully invested) since Dec-96, log scale
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Out Performance over Various Time Periods Investors will appreciate that past performance is not a reliable indicator of future performance
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Country and Sector Ranking Factors The core drivers of investment returns <ul><li>Valuation & Risk Premia </li></ul><ul><ul><li>Price to Book </li></ul></ul><ul><ul><li>Price to Reported Earnings </li></ul></ul><ul><ul><li>Price to Forward Earnings </li></ul></ul><ul><ul><li>Market Cap to historical mean </li></ul></ul><ul><li>Risk </li></ul><ul><ul><li>Beta </li></ul></ul><ul><li>Growth / Economic Disequilibrium </li></ul><ul><ul><li>Sales Growth </li></ul></ul><ul><ul><li>Reported Earnings Growth </li></ul></ul><ul><ul><li>Forward Earnings Growth </li></ul></ul><ul><li>Momentum </li></ul><ul><ul><li>Up revisions </li></ul></ul><ul><ul><li>Momentum 6mnth </li></ul></ul><ul><ul><li>Momentum 10mnth </li></ul></ul>Country Model <ul><li>Valuation & Risk Premia </li></ul><ul><ul><li>Price to Book </li></ul></ul><ul><ul><li>Price to Reported Earnings </li></ul></ul><ul><ul><li>Risk Premia </li></ul></ul><ul><ul><li>Market Cap to GDP </li></ul></ul><ul><li>Risk </li></ul><ul><ul><li>Beta </li></ul></ul><ul><ul><li>Real Exchange Rate </li></ul></ul><ul><li>Growth / Economic Disequilibrium </li></ul><ul><ul><li>Leading Economic Indicator </li></ul></ul><ul><ul><li>Industrial Production </li></ul></ul><ul><ul><li>Trade Balance </li></ul></ul><ul><li>Momentum </li></ul><ul><ul><li>Up revisions </li></ul></ul><ul><ul><li>Momentum 6mnth </li></ul></ul><ul><ul><li>Momentum 10mnth </li></ul></ul>Sector Model Developed Market bias Neutral Emerging vs. Developed Emerging Market bias Defensive bias Neutral Defensives vs. Cyclicals Cyclical bias
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Currencies…..Dollar, Sterling and the Euro <ul><li>Sterling is undervalued, by approximately 5-10%, with interest differentials and capital flows consistent with 1.73 versus the USD…PPP at 1.65 </li></ul><ul><li>Euro is overvalued, by approximately 10 -15%, with interest differentials and capital flows consistent with 1.24 versus the USD…PPP at 1.27 </li></ul>Source: Datastream, LODH Calculation
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Currencies…..the Swiss Franc <ul><li>The Swiss Franc is a Greek/Portuguese/Irish/Spanish default hedge, as shown in the correlation between the Greek CDS spread and the Euro / Swiss Franc exchange rate...the 20-25% valuation premium appears to reflect default risk, by and large.. </li></ul><ul><li>Euro is undervalued, by approximately 20 -25% versus the Swiss Franc, with interest differentials and capital flows consistent with 0.63 cents.. </li></ul>Source: Datastream, Bloomberg, LODH Calculation
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A 3-factor model on commodities <ul><li>We developed a multi-factor model on commodities that provides us with timely buy signals on each of the 4 commodity segments (Agriculture, Energy, Industrial and Precious Metals) </li></ul><ul><li>Our 3-factor model is based on </li></ul><ul><ul><li>an economic/risk indicator (US recession barometer) </li></ul></ul><ul><ul><li>a price momentum component </li></ul></ul><ul><ul><li>a valuation proxy (deviation from a long-term mean of the relative roll yield of the commodity segment versus that of the commodity global index) </li></ul></ul><ul><li>The net signal on a commodity segment is positive only when ALL 3 factors are positive </li></ul><ul><li>Monthly update of the signals </li></ul><ul><li>Backtested results are based on out-of-sample optimized parameters </li></ul>
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3-factor model Commodity Model recommendations Agriculture Energy Industrial Metals Precious Metals April 2011 Source: Lombard Odier Favor Energy and Agriculture. Negative Industrial Metals. Negative Precious Metals for 6th months (following 18 consecutive months of positive signal) + + Net signal - - + Valuation proxy + - - + Momentum + + + + Economic cycle + + +
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Performance of relative bets since last signal change Energy outperforms all segments, whilst Agriculture lags Precious Metals (using EXR indices) Last signal change Source: Datastream, Lombard Odier calculation + + - - Current signal Performance since last signal change (as of May 2011) 12% 43% 19% 3% 11% 34% 19% 12% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% AG PM EN IM AG PM EN IM Excess return index Spot index
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Factor 1: Economic / Risk indicator <ul><li>Our US recession barometer is a good proxy for the economic and risk environment for commodities </li></ul><ul><li>It is based on the levels and dynamics of 5 variables : 1) S&P 500, 2) T-Bill vs. CP spread, 3) 3m T-Bills vs. 10y yield spread, 4) payroll growth, 5) ISM manufacturing </li></ul><ul><li>The indicator is reliable, with 89% correct signals (in or out of recession) since 1960 </li></ul>Source: Bloomberg, Datastream, Lombard Odier calculation US recession barometer 0 62 66 70 74 78 82 86 90 94 98 02 06 10 Recession signal (when all factors are "negative") NBER official recession periods As of May 2011, the probability of recession in the US is 20% (with only payroll growth flashing red) 20% 100% Signal is POSITIVE for all commodities when there is no recession
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Factor 2: Price Momentum Signal is POSITIVE when index level > optimal moving average Source: Datastream, Lombard Odier calculation Agriculture: Price index (GSCI Excess Return) and optimal moving average Energy: Price index (GSCI Excess Return) and optimal moving average Precious Metals: Price index (GSCI Excess Return) and optimal moving average Industrial Metals: Price index (GSCI Excess Return) and optimal moving average Price index (GSCI EN EXR) Optimal movav Price index (GSCI IM EXR) Optimal movav 250 Price index (GSCI AG EXR) Optimal movav (44M) Price index (GSCI PM EXR) Optimal movav 0 50 100 150 200 88 90 92 94 96 98 00 02 04 06 08 10 0 100 200 300 400 500 600 700 800 900 88 90 92 94 96 98 00 02 04 06 08 10 0 50 100 150 200 250 300 350 400 88 90 92 94 96 98 00 02 04 06 08 10 0 50 100 150 200 250 300 88 90 92 94 96 98 00 02 04 06 08 10
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Factor 3: Relative roll yield as a valuation proxy Signal is POSITIVE when relative roll deviation > 0 Source: Datastream, Lombard Odier calculation Agriculture: Deviation of the relative roll (segment vs. overall) from LT trend (z-score) Energy: Deviation of the relative roll (segment vs. overall) from LT trend (z-score) Industrial Metals: Deviation of the relative roll (segment vs. overall) from LT trend (z-score) Rel roll deviation GSCI AGEXR index Rel roll deviation GSCI ENEXR index Rel roll deviation GSCI IM EXR index Precious Metals: Deviation of the relative roll (segment vs. overall) from LT trend (z-score) Rel roll deviation GSCI PM EXR index 88 90 92 94 96 98 00 02 04 06 08 10 roll favorable to 88 90 92 94 96 98 00 02 04 06 08 10 roll favorable to Precious Metals = POSITIVE roll unfavorable to Precious Metals = NEGATIVE roll favorable to PM = POSITIVE roll not fav to PM = NEGATIVE -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 0 50 100 150 200 250 300 roll unfavorable to Energy = NEGATIVE roll favorable to Energy = POSITIVE -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 0 100 200 300 400 500 600 700 800 900 roll unfavorable to Agriculture = NEGATIVE roll favorable to Agriculture = POSITIVE -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 88 90 92 94 96 98 00 02 04 06 08 10 0 50 100 150 200 250 Industrial Metals = POSITIVE roll unfavorable to Industrial Metals = NEGATIVE -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 88 90 92 94 96 98 00 02 04 06 08 10 0 50 100 150 200 250 300 350 400
61.
Backtested results of the model strategy since 1988 Higher returns, lower volatility, more limited DD than benchmark Source: Datastream, Lombard Odier calculation Model strategy (4 commodity segments) vs benchmark (GSCI) The model strategy has a clear ABSOLUTE RETURN bias: it participates on the upside with a lag, but tends to successfully avoid the drawdowns Model Strategy (4 segments) Annualized return 5.67% Annualized volatility 6.38% Sharpe Ratio (net) 0.89 Max DD 12.95% GSCI EXR index Annualized return 3.08% Annualized volatility 21.39% Sharpe Ratio (net) 0.14 Max DD 70.11% 0 200 400 600 800 1000 1200 88 90 92 94 96 98 00 02 04 06 08 10 Benchmark (GSCI Excess Return Index) Model Strategy (4 segments)
65.
US Equity Market since 1870 (Shiller, Log Scale)
66.
Emerging Markets...Expected EPS Growth is Identical <ul><li>Anyway …. Ignore analysts who talk about the Price versus NEXT YEAR’S earnings ….it is irrelevant, it has NO predictive power at all! The price versus 12-month forward earnings tells you nothing at all about prospective EME returns... </li></ul><ul><li>Expected Earnings PER SHARE growth in the next year is identical in EM and Developed Markets…why pay a premium for the same growth rate, with a lower dividend yield? </li></ul>Source: Datastream, LODH Calculation
67.
Large versus Small and Mid Cap… <ul><li>Small Cap valuation is at extremes versus Large Cap stocks: given that Small Cap is a good proxy for Private Equity valuation, it signifies a high price for illiquidity and market risk and a low price for defensiveness … </li></ul><ul><li>Large Cap stocks have lagged badly in the rally since 2009 and are unusually cheap against Small and Mid Cap stocks: they are attractively valued and defensive at aggregate US market levels which are meaningfully overvalued … </li></ul>Source: Datastream, LODH Calculation
68.
Small Cap as a Private Equity Proxy… <ul><li>This implies comparatively low implied annualized holding period returns between -1% to 5%, with an implied risk premium from -3% to +4% …you don’t get early 1980s “Swenson PE returns” from current valuations and financing constraints … </li></ul><ul><li>Small Cap stocks are a highly correlated proxy for Private Equity Valuations / Returns: current Small Cap valuation is at elevated and unattractive levels.. </li></ul>Source: Datastream, LODH Calculation
69.
Corporate Credit…..Fair Value <ul><li>However, the Debt/Profit ratio and the Financing Gap [Free Cash Flow surplus / deficit], are consistent with narrower credit spreads … </li></ul><ul><li>Corporate Spreads at fair value, on the basis of Altman Z-Score variables… </li></ul>Source: Datastream, LODH Calculation
70.
Ten Year US Treasury Yield…Fair Value <ul><li>Approximately 14.5% of Commercial Bank assets are held in Government Securities, still well below the level prevailing after the 1991 recession… </li></ul><ul><li>We have modelled, and can explain 78% of the variation in, US 10 Year Treasury Yields using just short rates and trailing inflation…the level of yields is currently in equilibrium on this basis…. </li></ul>Source: Datastream, LODH Calculation
71.
Gold as an Inflation hedge …forget it.. <ul><li>A regression of Gold Inflation on UNEXPECTED Consumer Price Inflation shows much the same picture : a very ineffective, very modest hedge against inflation surprises….Gold is a very poor hedge against both realized and surprise inflation, confirming Prof Roy Jastram’s conclusion in “The Gold Constant”… </li></ul><ul><li>A regression of Gold Inflation on REALIZED Consumer Price Inflation shows Gold to be a very ineffective hedge : less than one fifth of the variation in Gold Inflation is explainable by Consumer Inflation and the coefficient is low </li></ul>Source: Datastream, LODH Calculation
72.
Gold….sell Physical and buy a Mine <ul><li>Silver / Gold price ratio at extremes …sell Silver / buy Gold [miners]… </li></ul><ul><li>The ratio of Gold Bullion / Miners is the yield on a Gold Mine….short physical / long the producer ..$/Ounce of Gold = $/FC * FC/ounce of Gold. So higher Gold = lower dollar and/or higher foreign currency price of Gold.. </li></ul>Source: Datastream, LODH Calculation
73.
“ PIGS” Need to Turn German .. <ul><li>Unit Labour Cost restraint implies absolute and relative cost / price deflation …unless Germany agrees to inflate?! The peripheral countries need to deflate nominal income in excess of 20%...unprecedented </li></ul><ul><li>Germany in the decade after the introduction of the Euro is the model PIGS need to follow…de-leveraging and cost discipline, the lost art of saving! </li></ul>Source: Datastream, LODH Calculation
74.
China…Don’t Rely on the Consumer…. <ul><li>… China is already urbanized, overrun with capacity and with investment at 55% of GDP…. and with bubbles in housing and equity </li></ul><ul><li>Consumers cannot spend what they do not have !...the Household share of National Income has declined markedly in the last decade.. </li></ul>Source: UN, IMF, National Data Sources 96% of Chinese population lives in 46% of land mass 96% of US population lives on 66% of US land mass USA has 4.2 mn km of Paved Roads / 80,000 km of Highways China has 2.7 mn km of Paved Roads / 60,000 km of Highways China uses per Capita Energy 6 * that for Italy / 3* that for the USA Chinese Homeownership rate = 86% US Homeownership rate = 67%
75.
US Implied Index Returns: 2009 Low Source: Datastream, LODH Calculation
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US Implied Index Returns: May 2011 Source: Datastream, LODH Calculation
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US Implied Index Returns: 2000 Bull Market Peak Source: Datastream, LODH Calculation
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UK Implied Index Returns: 2009 Low Source: Datastream, LODH Calculation
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UK Implied Index Returns: May 2011 Source: Datastream, LODH Calculation
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UK Implied Index Returns: 2000 Bull Market Peak Source: Datastream, LODH Calculation
81.
Russia Implied Index Returns: 2006 Peak Source: Datastream, LODH Calculation
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Russia Implied Index Returns: 2009 Low Source: Datastream, LODH Calculation
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Russia Implied Index Returns: May 2011 Source: Datastream, LODH Calculation
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