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  • 1. Edition 3/3 Investment conclusions INVESTMENT STRATEGY The evidence suggests that the US economy PRIVATE BANKING cannot recover vigorously without an increase in private sector leverage. Given that the deleveraging process is only in its early stages and that households and banks are still excessively leveraged, it seems unlikely that we will see a strong revival in private sector borrowing in the near future to fuel economic recover and create jobs. Growth will more likely 4th quarter 2009 remain below-potential for a protracted period. • Overall, at current US valuation levels, with self sustaining recovery and earnings growth both tied to the unwinding of leverage, we would be cautious on the prospects for developed equity markets in general. The “easy” money has been made and, with so much dependent now on the follow-through from earnings, investors should not chase the market. • We see gold to be the asset of choice in a deflationary environment and not a useful inflation hedge. • Bond yields will remain depressed for some time, as a reflection of the ongoing deleveraging in the financial system. With bank balance sheets still under repair, the rapid deposit growth as savings rates rise provide banks with liquidity that should flow into government debt. Quarterly publication of the Private Banking Investment Services of Lombard Odier Darier Hentsch IMPORTANT INFORMATION Please see important information at the end of this document. Data as of October 6, 2009
  • 2. Where do we stand today in the process of deleveraging our economies? “By totally protecting secured We have long argued that it is unjust, We agree with Mrs Bair that the cur- nomic Research) recession end date. It unfair, and inappropriate of govern- rent system actually encourages and is clear that the smaller the rate of lia- claims and many repo ments to try to place taxpayers between incentivizes excess risk taking. We think bility growth, as in 1991, 1980, and 2001, common equity holders and bank debt her speech is the single most important the more anemic the rate of economic claims as nettable financial holders in the capital structure of statement by any policymaker, in any growth (this holds strongly for the first contracts, the current priority banks. Such measures merely shield se- country, since the onset of the crisis. three years of an economic recovery). cured debt holders from their rightful scheme may encourage place in the hierarchy of losses, when There is a glimmer of hope that poli- greater fragility in the financial institutions fail. For example, cymakers might finally be addressing Growth needs liabilities, just the investors who provided the USD the heart of the problem, rather than as green shoots need water. financial markets.” 500 bn of long term debt to Citigroup just glossing over it with reactionary to make poor and ill-timed investment political gestures and reckless fiscal Sheila Bair, FDIC Chairman, Istanbul, decisions did not share in the losses stimulus. Nonetheless, the process of Moreover, the faster the rate of recov- October 4, 2009 but instead earned a risk premium at deleveraging the system continues. ery, driven by liability accumulation, the government’s expense. This cre- the greater the rate of new payroll To date, US real private liabilities have ates a perverse incentive for banks to growth: the chart III (page 3) shows that grow to a scale that threatens systemic declined 5.2% from their peak in early payrolls expand in linear proportion to failure, with a mountain of debt and 2008, with real credit market debt the rate of growth in the economy. Con- without any implied risk to investors. down just 2.5% from peak levels (mar- sequently, it has typically required real At last, as the quotation from Sheila ginally less than the decline we saw GDP growth of 4% in the first year of Bair demonstrates, at least one US in 1975). Household real credit market recovery, and growth in excess of 3.5% policymaker appears to share our view. debt has declined 3% from the 2008 over the cycle to reduce the unemploy- She understands that the recent res- peak, a decline not dissimilar to that ment rate (see chart IV, page 4). of the recessions in the 1970s and the early 1980s (see chart I, page 3). To us, the case seems quite clear: liabili- Leverage is a vital ingredient ties are always needed to fuel economic Many analysts have attempted to ar- of economic recovery and also recovery and the more the better. Ad- gue that deleveraging does not have ditionally, economic recovery is always a very significant influence any implications for the path of growth needed to create jobs and reduce the on equity market returns. in the economy and, by default, the unemployment rate. The empirical evi- path of likely future equity returns. dence is compelling: an economy inca- A look back at the empirical evidence pable of creating / accumulating more cue of the major US banks (and banks provided in prior recessions suggests liabilities or in a state of deleveraging elsewhere), while necessary, could and to us that leverage is a vital ingredient is incapable of generating sufficient, should have been done in such a way of economic recovery. It also has a very sustainable economic growth to im- as to penalize debt holders and not significant influence on equity market prove labor market conditions. Growth taxpayers. Moreover, she demonstrably returns through its undeniable impact needs liabilities, just as green shoots appreciates that no amount of fiscal on return on equity. The chart II (page need water! stimulus, hand-wringing, and banker- 3) shows the annualized rate of growth baiting will prevent a recurrence of this in real private liabilities versus the an- While there is a continuing need for scenario, unless the owners of debt nualized rate of growth in real US GDP private deleveraging, one other impor- suffer the consequences of excessive in the first year of recovery after the tant element of the credit / liability cre- debt-financed risk taking unilaterally. official NBER (National Bureau of Eco- ation process in the United States casts Please see important information at the end of this document. 2 Lombard Odier · Investment Strategy – Private Banking · 4th quarter 2009
  • 3. doubt on the ability of the financial sys- a longer-run perspective. The chart VI I. Real non government US total liabilities: percentage drawdown from tem to fuel a self-sustaining recovery. (page 4) shows the S&P500 trading at trailing peak level The chart V (page 4) shows credit mar- 15 times next year’s operating earnings. 0% ket debt, i.e. securitized debt, at 44% of Based on this widely used and accepted outstanding private liabilities (while valuation metric, the S&P500 is trading -1% accounting for 50% of the growth in at a valuation multiple typically only ob- Q3 2002; -1.2% total private liabilities in the last five served at the very top of prior bull mar- -2% years, versus a more normal 40%). If kets (valuation peaked at 15x in 1961, banks shrink their balance sheets and 1971, 1987, 1992, and 2007). Moreover, a -3% the cost of funding rises, it is unlikely decile ranking of the returns associated that the securitized credit markets will with this level of valuation shows that Q4 1974; -3.7% -4% be able to either roll over the debt ac- it has typically generated a holding pe- cumulated in the peak 2005-2007 pe- riod return of just 6% annualized over riod or provide the flow of new debt to the course of the cycle. The only time -5% Q2 2009; -5.2% underpin private activity (securitized we traded above the 15x valuation mul- credit typically represents 40-42% of tiple was during the great IT bubble, -6% new liabilities in the first one to three and we know what happened to invest- Q1 1953 Q1 1962 Q1 1971 Q1 1980 Q1 1989 Q1 1998 Q1 2007 Sources: Datastream, Lombard Odier calculation years of a cycle). ment returns after that period! We have always questioned the rela- Returns from the market trough in tionship between economic activity March have been almost unprecedent- II. Annualized % change in real private liabilities vs annualized % change in and asset market returns, either from ed and entirely driven by multiple ex- real GDP one year to the next or over the course pansion, from 10 to 15 times forward 10 of a cycle. However, where market par- operating earnings, but any progress For 4 quarters following official NBER recession end date ticipants believe there to be an exploit- from here must now be made by im- 1954 able link, the process of deleveraging provement in the denominator of the 8 y = 0.8x + 0.5 R2 = 0.7 1982 seriously questions the assumptions P/E, namely earnings. This is where 1970 1961 1958 6 The S&P500 is trading at a valuation multiple typically only observed at the very top of prior bull markets. 4 1991 1975 1980 2 underpinning current equity valua- we return to the issue of leverage / de- tions. We favor valuing equities versus leveraging. 2001 the normalized level of earnings / cash 0 flows generated by normalized return The last serious recession was in the 0 2 4 6 8 10 on equity assumptions (it helps us early 1980s. Since then, the United Sources: Datastream, Lombard Odier calculation remove the speculative component States has experienced three secular of return prospects and to avoid be- debt cycles: these are shown in the ing caught up in fashionable themes). chart VII (page 5) as three distinct pe- III. Annualized % change in real US GDP vs annualized % change in non farm Nevertheless, we are regularly asked riods of substantial net debt issuance payrolls about the market valuation versus alongside net equity retirement. These 12 next year’s earnings. Market valuation cycles peaked in 1986/87, 1999/00, and For 4 quarters following official NBER recession end date versus forward operating earnings has finally 2007/08, and were followed by a y = 1.4x + 2.8 10 R2 = 0.9 been possible using IBES estimates only return to balance. Such leverage waves 1958 since the mid 1980s. This period is not are immensely important because they 1954 demonstrate how “financial engineer- 8 1961 long enough to form a view of normal- 1982 ity, since it was dominated by a credit ing” can exaggerate earnings growth and provoke unsustainable valuations. 6 1975 boom, the IT bubble, and the banking collapse. Consequently, we have mod- We know that earnings are simply the 1970 eled analysts’ forward earnings expec- book value (net liquidation value) mul- 4 1991 1980 tations for the S&P500 in the post-war tiplied the return on equity. Moreover, period (analysts appear to mark record it is straightforward to prove that the 2 trailing earnings up 20%-25% and then return on equity is just the product of 2001 make an adjustment for the point of the profit margins, turnover, and, impor- 0 economy in the cycle) in order to obtain tantly, leverage! -1 0 1 2 3 4 5 6 Sources: Datastream, Lombard Odier calculation Please see important information at the end of this document. Lombard Odier · Investment Strategy – Private Banking · 4th quarter 2009 3
  • 4. IV. Annualized % change in real US GDP vs change in unemployment rate Increasing leverage by buying back sell real estate, commodities, stocks, equity and issuing debt (as is the fa- and bonds; and the real economy 12 vourite strategy of private equity inves- where supply is plentiful, due to mas- y = -2.2x + 4.1 R2 = 0.9 tors), improves earnings and makes the sive excess investment in Asia, and 10 1958 market look particularly cheap, before where people actually make goods and stock prices rise accordingly. The im- provide services. The Chinese response 1954 pact of leverage on earnings is shown to the global debt crisis is to add to 8 1982 1961 in the chart VIII (page 5). The deviation supply potential, in the hope that the 1975 of earnings per share from trend is goods will find a western deficit to fill. 6 driven by the net debt cycle. Periods of This is adding structural fuel to global 1970 net debt issuance / equity retirement deflationary pressures, which are also 4 1980 coincide with elevated earnings levels heightening cyclically, as a consequence 1991 and exaggerated valuation levels. of the recession and widening output 2 gap. The next cyclical recovery is highly 2001 Not only does the leverage cycle drive unlikely to resemble the recent experi- For 4 quarters following official NBER recession end date 0 the growth cycle, but it also determines ence of debt-driven deficits. This means -4 -3 -2 -1 0 1 2 the earnings cycle. There is little hope of that the Chinese might have prepared Sources: Datastream, Lombard Odier calculation more leverage (the three secular waves themselves for the wrong kind of recov- of debt issuance and equity buyback ery. As a consequence, the real part of are behind us) and margins are unlikely the economy has a structural deflation V. US private sector credit market debt / US private sector total financial to expand materially. In a deflationary bias that is worsening by the day. liabilities world where costs, more than prices, 50% drive margin levels, the prospects for This can be seen in the chart IX (page a material increase in the return on 5) of our inflation diffusion indices, 48% equity to levels sufficient to meet earn- which measure the breadth of sectors 46% ings expectations look modest at best. on the real part of the economy that Q4 1974; 44% Q1 2009; 44% 44% Earnings expectations implicit in to- are raising prices versus cutting prices. day’s S&P500 valuation not only imply Deflationary pressures are substantial 42% 40% 40% 38% The real part of the economy has a structural 36% Q1 2000; 37% deflation bias that is worsening by the day. 34% 32% modest returns of around 6% but, even and worsening in Japan. Meanwhile, 30% for that level of implied return, look dif- the United States is showing increasing Q1 1952 Q1 1961 Q1 1970 Q1 1979 Q1 1988 Q1 1997 Q1 2006 Q1 2015 ficult to achieve. signs of deflationary pressure. Europe, Sources: Datastream, Lombard Odier calculation with a greater extent of administered As a consequence, when we look at prices, has limited deflationary pres- markets in terms of valuation, implied sure at the consumer level. This struc- risk premiums, momentum, and the tural deflationary bias will remain in VI. S&P500 price / forward operating earnings ratio sustainability of surpluses / deficits and the global economy for just as long assets / liabilities, we consider the US as markets remain global and supply 30 market to be among the most unat- remains plentiful: the primary threat tractive. Prospects appear more favor- to those conditions would almost 25 able for the European bloc, particularly certainly come from a renewal of pro- the UK, Italy, and Germany. However, tectionist pressures, turning bounti- 20 P / IBES E the degree of influence of the US mar- ful global markets into tighter local 15 * (peak in 1961, 1974, 1987, 1994, 2007) ket is such that current prospects and markets. As a result, we are watching 15 the ongoing process of deleveraging developments very closely. Despite re- make us considerably more cautious cent Chinese / US exchanges over car 10 on the outlook for equity returns from tire imports, we see little serious threat P / Modelled E these levels. in this area at this point in the cycle, but expect trade tensions to elevate in 5 6 * (low) We have, in past notes, broken the coming years as Chinese investment economy into two distinct parts: the spending seeks a home for its product. 0 monetary economy, where supply is In the meantime, what is the best way 12.1955 12.1965 12.1975 12.1985 12.1995 12.2005 12.2015 constrained, and where people buy and to invest in a deflationary world? Sources: Datastream, Lombard Odier calculation Please see important information at the end of this document. 4 Lombard Odier · Investment Strategy – Private Banking · 4th quarter 2009
  • 5. Strange as it seems, we consider gold unwinding of leverage and implied re- VII. Net funds raised in credit markets by the US non financial corporate to be the asset of choice for a deflation- turns over the cycle are little more than sector vs net equity market issuance (% of GDP, annualized) ary world and not, as most analysts 6% at current US valuation levels. The 8 believe, a useful inflation hedge. In a “easy” money has been made and, with seminal study, the late Professor Roy so much dependent now on the fol- 6 Debt Jastram (“The Golden Constant”, 1977) low-through from earnings, investors 4 looked at the behavior of gold from should not chase the market. As long the 16th century and concluded that it as emerging equity markets continue 2 was a particularly poor hedge against to trade at an unjustifiable premium to 0 inflation (gold prices have lagged infla- developed markets, we would similarly tion materially in the last 30 years) but retain a cautious outlook. -2 Paul Marson, CIO -4 Gold is the asset of choice -6 Equity for a deflationary world and -8 not a useful inflation hedge. Q1 1980 Q1 1985 Q1 1990 Q1 1995 Q1 2000 Q1 2005 Q1 2010 Q1 201 Sources: Datastream, Lombard Odier calculation a particularly effective hedge against deflation. Deflationary periods tend to coincide with periods of financial stress VIII. Earnings per share and non-financial corporate sector credit market and gold provides a useful defense debt against systemic risks. As an aside, 6 50 equity valuation multiples tend to be 40 immune to inflation rates except at the Net debt insuance / GDP deviation 4 from trend (%, l.h.s.) 30 extremes: they are lower (and implied returns correspondingly higher) during 20 2 periods of deflation and double-digit 10 inflation. 0 0 Finally, our analysis of corporate debt -10 spreads suggests that, after widening -2 -20 dramatically in the 1st quarter 2009, -30 spreads have now returned back to -4 levels we would consider to be fair EPS deviation from trend (%, r.h.s.) -40 value and appropriate given the un- -6 -50 derlying condition of the corporate 03.1982 03.1988 03.1994 03.2000 03.2006 03.2012 sector. Government bond yields re- Sources: Datastream, Lombard Odier calculation main significantly below what most analysts would consider long-run fair value, despite recent cyclical and fis- IX. Core deflation-watch indices cally driven improvement in economic activity. We anticipate that yields will 120% remain depressed for some time, as a Inflationary pressures reflection of the ongoing deleveraging 100% in the financial system. Given banks’ re- Euroland luctance to supply credit, the reduced demand for credit, and the ongoing re- 80% pair work on bank balance sheets, rapid deposit growth is providing banks with 60% United States liquidity that should naturally flow into government debt, as it did in Japan af- 40% Disinflationary pressures ter 1990. Japan 20% Overall, we would be cautious on the G3 deflation watch diffusion indexes (core) (6mmovav) (dot = last avail. data): when index is prospects for developed equity markets >50% inflationary pressures, when <50% disinflationary pressures 0% in general: self-sustaining recovery and 1972 1975 1978 1982 1985 1988 1992 1995 1998 2002 2005 2008 earnings growth are both tied to the Sources: Datastream, Lombard Odier calculation Please see important information at the end of this document. Lombard Odier · Investment Strategy – Private Banking · 4th quarter 2009 5
  • 6. IMPORTANT INFORMATION This document reflects the opinion of Lombard Odier Darier Hentsch & Cie or an entity of the Group (hereinafter “Lombard Odier”) as of the date of issue. This document is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor it is directed to any person or entity to which it would be unlawful to direct such a document. This document is furnished for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security. The opinions herein do not take into account individual clients’ circumstances, objectives, or needs. Each client must make his own independent decisions regarding any securities or financial instruments mentioned herein. Before entering into any transaction, each client is urged to consider the suitability of the transaction to his particular circumstances and to independently review, with professional advisors as necessary, the specific risks incurred, in particular at the financial, regulatory, and tax levels. The information and analysis contained herein have been based on sources believed to be reliable. However, Lombard Odier does not guarantee their timeliness, accuracy, or completeness, nor does it accept any liability for any loss or damage resulting from their use. All information and opinions as well as the prices indicated are subject to change without notice. Past performance is no guarantee of current or future returns and the client may consequently get back less than he invested. Performance data of mutual funds do not take into account the commissions and fees charged on the issue and redemption of the units or shares. The investments mentioned herein may be subject to risks that are difficult to quantify and to integrate into the valuation of investments. Generally speaking, products with a high degree of risk, such as derivatives, structured products, or alternative / non-traditional investments (Hedge Funds, private equity, real estate funds, etc.) are suitable only for sophisticated investors who are capable of understanding and assuming the risks involved. Upon request, Lombard Odier is available to provide more information to clients on risks associated with specific investments. If opinions from financial analysts are contained herein, such analysts attest that all of the opinions expressed accurately reflect their personal views about any and all of the subject securities or issuers. In order to ensure their independence, financial analysts are expressly prohibited from owning any securities that belong to the research universe they cover. The description of the rating system used by Lombard Odier for its financial research is available on This document may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Lombard Odier. © 2009 Lombard Odier Darier Hentsch & Cie – all rights reserved.
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