The New Normal is Non-Normal

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Yves Bonzon, Chief Investment Officer of Pictet Wealth Management, presented his view for the year ahead in London on January 24th.

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The New Normal is Non-Normal

  1. 1. Secular Trends year 3 - Strategy 2012The New Normal is Non-NormalPWM investment strategyYves Bonzon, CIOJanuary 2012
  2. 2. Key 2010’s trends Every decade is characterized by a different economic and investing environment 60’s 70’s 80’s 90’s 00’s 10’s Bretton Woods Floating FX Disinflation Fall of Berlin EMU Oil shock Plaza Wall Great global Inflation Arbitrage Globalization imbalance Internet China’s rise ? E-trading Structured credit US Nifty Fifty Small Caps Gvt bonds Indexing Hedge funds stocks Oil stocks Nikkei Nasdaq EM equities Gold, CHF and Hang Seng SMI Commodities JPY USD EURPictet Secular Trends Year 3 - Strategy 2012 3
  3. 3. 1945 – 2007 leveraging cycle2007 was an inflexion US debt to GDPpoint in terms of debtaccumulation inWestern economies.We have entered themanaged deleveragingera.Pictet Secular Trends Year 3 - Strategy 2012 7
  4. 4. In a balance sheet recessionKey Points • Austerity is doomed to fail • Three solutions to insolvency: - Transfers, money printing, restructuring • Capital flees from weak balance sheets to strong ones. • Strong countries resist the appreciation of their currencies. • A coordinated solution is unlikely.Pictet Secular Trends Year 3 - Strategy 2012 8
  5. 5. US employmentNo net creation in 12 yearsUS total payroll employment excluding census hiring: level in millions of workers Mio 135 130 November 1999 125 120 115 110 105 100 95 90 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 9
  6. 6. Household formation was very weak over the past 5 years or soIt should re-accelerate over the coming years. Moreover, “shadow demand” has built up Number of households: effective and trend estimatesOn trend, the natural rate of UShousehold formation is about 1 million Millionsannually. 116 2.7The depressed level of housing activity 114and the missing 2 or 3 million jobs 112 Number of householdsrelated have depressed householdformation to the same extent. 110Fundamentally US demographics are Trend based on 108 adult populationnot deflation prone, unlike Japan. 106 104 102 100 00 02 04 06 08 10 12 Source: AA&MR, Datastream Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 10
  7. 7. US house pricesOne of the cheapest US house price indexesinvestable asset class 7.6but the overhang is not 37%cleared yet. Decline 7.4 15% DeclineUS families will switch R Average E eal xisting House P (log scale) ricefrom an owner’s 7.2 R C eal ase-Shiller C posite Index (log scale) om R O E /FH H eal FH O FA ouse P Index (log ricementality to a rentalmentality. This is a 2generations’ turn. 7.0 30% 6.8 Decline 6.6 6.4 Trend = 1.5%per annum 1 SD = 6.7% Source: CS 6.2 Jan-68 Jan-71 Jan-74 Jan-77 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10Pictet Secular Trends Year 3 - Strategy 2012 11
  8. 8. China’s economy at horizon 2015China would reach between 12% and 16% of world GDP by 2015 at 6% respectively 9% real growthChina’s nominal GDP share in world GDP 18% USD* 10076 bn 16% 14% Bull Case (9% growth) Bear Case (6% growth) 12% 10% USD* 9073 bn USD* 4814 bn 8% 6% USD* 2224 bn 4% USD* 1196 bn 2% *2004 constant USD 0% 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 16
  9. 9. China: middle income trap?Few people realize how China may be old before it gets richfast China is aging.Labour force is actuallystarting to decline fromnext year onwards.Furthermore, they mightbe caught in a middleincome trap where theybecome too expensiverelative to place such asVietnam and not skilledenough relative toadvanced countries.Pictet Secular Trends Year 3 - Strategy 2012 21
  10. 10. Gold: target raised to $ 3’000.- (from $2’000.-)We are slowly getting towards Dow/Gold ratioof target ratio of 5 ounces ofgold for 1 unit of the DJIndustrial Index.Monetary disorder of thedeflation or inflation kindwould justify a lower ratio.In nominal terms, if deflation Insert here your graphsultimately prevails, $ 2’000.- and tablesis the maximum potential.If inflation gets out of controlgold might be confiscated.Pictet Secular Trends Year 3 - Strategy 2012 25
  11. 11. Corporate bonds Quality corporate bonds are historically the best asset class in a de-leveraging cycleUS corporate bond yield US corporate bond spreads % % Bp 13.2 380 6.0 1050 Bp 12.6 5.8 360 1000 12.0 5.6 340 950 11.4 5.4 900 320 10.8 5.2 5.0 850 Investment 300 10.2 High yield 4.8 grade 800 280 9.6 4.6 750 9.0 260 4.4 8.4 700 High yield 4.2 240 7.8 650 4.0 Investment grade 220 7.2 600 3.8 550 200 6.6 3.6 Merrill Lynch Master index Merrill Lynch Master index 6.0 3.4 500 180 H2 09 H1 10 H2 10 H1 11 H2 11 H1 12 H2 09 H1 10 H2 10 H1 11 H2 11 H1 12 Source: AA&MR, Datastream Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 30
  12. 12. Investment rules in a deflationary environmentKey Points • Favour strong balance sheet linked investments. • Beware the pitfalls of low valuations. • Focus on: – Cash and government bonds of countries that can print their money – High grade corporate bonds – Defensive equities – Gold • Minimize leverage.Pictet Secular Trends Year 3 - Strategy 2012 31
  13. 13. SAA: allocating capital by strategies and risk factorsWe shall progressively PWM strategic asset allocation 2012move to an assetallocation driven by E 2 3 4 Fixed income Conservative Balanced Growth Strategiesstrategies and riskfactors. Credit risk premiaThe TAA bucket will be EM debt FXimplemented through Goldbeta instruments.For the other buckets, TAA bucketwe shall use a variety ofsuitable portfolios andinstruments. Alternatives trading Equity defensive Equity growth Alternatives low vol REITsPictet Secular Trends Year 3 - Strategy 2012 34
  14. 14. Pictet’s secular outlook: summaryKey Points • Bimodal distribution of returns on financial assets. • Diversify by strategies rather than by asset classes and dedicate capital to a tactical bucket. • GDP growth is the dominant variable for equities. • Policy decisions trigger violent rallies. • Emerging equities are only a super cyclical asset class. • Financial repression has begun.Pictet Secular Trends Year 3 - Strategy 2012 35
  15. 15. Key 2010’s trendsEvery decade is characterized by a different economic and investing environment 60’s 70’s 80’s 90’s 00’s 10’s Bretton Woods Floating FX Disinflation Fall of Berlin EMU Managed Western Oil shock Plaza Wall Great global de-leveraging Inflation Arbitrage Globalization imbalance EM Internet China’s rise discrimination E-trading Structured credit Tech led cycle Asset price targeting End of $ paper standard or EUR ? US Nifty Fifty Small Caps Gvt bonds Indexing Hedge funds TAA and risk stocks Nasdaq EM equities factor based SAA Oil stocks Nikkei SMI Commodities Gold Gold, CHF and Hang Seng JPY USD EUR EM local debt Oil services Developed quality blue chipsPictet Secular Trends Year 3 - Strategy 2012 37
  16. 16. Double global decoupling in DMs versus EMs Tail event scenario Central scenario Alternative scenarioFiscal union on BCE’s QE. No growth in EU and growth Intensification of the euroFiscal policy boost in DMs. recession in the US. Stabilizing crisis. Double-dip in DMs. QEAccelerating economic growth in EMs. in DMs source of inflation ingrowth in DMs. No debt crisis in EMs. EMs. Economic policies are not coordinated, not cooperative, not homogenous. They generate disequilibrium. Emerging DevelopedRise in Markets Marketslabour QEcosts New supply side Double decoupling economics Diffusion of Debt deflation inflation Credit Change in the overhangStrong economic model from exports- Sluggishrevenues based to revenuesgrowth domestic based- growth Keynesianism Buoyant domestic demand demand Lack of domestic demandPictet Secular Trends Year 3 - Strategy 2012 Source: AA&MR 42
  17. 17. From 2008, DM economies have entered an over-indebtedness regime ebt Consensus 5y avg real growth rate 2012 - 2016 Insolvency Territory blic d of pu Debt / GDP ratio 2011 ct ory Traje 2008 Solvency Territory Portugal Ireland 0.4 % 2.2 % 101.6 % 108.1 % Greece Germany* 0.7 % 1.5 % 162.8 % Australia 81.7 % 3.3 % Italy 22.8 % Japan 0.7 % New Zealand 1.5 % 120.5 % 2.9 % 35.3 % 220 %1980 Switzerland Spain Great 1.6 % United Kingdom* 38 % 2.1 % 1.7 % 69.6 % divergence 84 % Public debt Norway Sweden 2.7 % 2.2 % to GDP ratios 40.9 % 36.3 % USA* 2.7 % France start rising in 101 % 1.5 % DM’s 85.4 % Traje ctory of no Debt-financed economic growth m inal e cono mic g rowth Debt is out of control without drastic * Prevailing market status of sovereign bonds issued by measures to cut debt or to boost these countries still allow us to consider them as solvable economic growth Source: AA&MR Pictet Secular Trends Year 3 - Strategy 2012 43
  18. 18. In an over-indebtedness regime, DM governments have 3 incompatible targetsSet of economic policy responses Governments’ targets Outcomes Political target: Re-election Innovation shock Reallocation of the added value from capital to labor Supply side Keynesian pro-growth Cuts in economics fiscal policy Government spending? European fiscal union Increase in Public deficit public debt to? Default and restructuring GDP ratio Monetization? of debt Satisfying financial markets’ requirementsSet of possible European crisis Source: AA&MR,responsesPictet Secular Trends Year 3 - Strategy 2012 44
  19. 19. The five possible outcomes of the euro crisis Euro outcomes Economic scenario Ultimate form: European government Fiscal union European fiscal policy Probabilities Euro-bonds Growth at potential 20% Low volatility The euro remains the Monetization of debt 35% euro (risk of Greece exiting the by the ECB Mild growth Eurozone) Medium volatility European systemic risk 20% Blue euroEuropean Political burst Mild recession Red eurodebt crisis High 20% volatility Euro = D-Mark zone Global systemic risk Sovereignty of States 5% + 11 national currencies Deep recession Implosion: Sovereignty of States 17 national currencies Source: AA&MRPictet Secular Trends Year 3 - Strategy 2012 45
  20. 20. Identifying 3 market regimes with the VIXA rule of thumb on market VIX index (new VIX starting January 1990)volatility 80 150 on 19 October 198710 - 15, low volatility regime 7015 - 25, significant risk 60Above 25, fear of systemic risk Systemic risk 50After the Euro Summit of 27 40and 28 October, the VIXreverted back to 25 on before Cycle with 30 some risksky rocketing again after thePapandreou proposedreferendum announcement. 20 10 Standard cycle 0 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 46
  21. 21. Pictet’s FX barometer: market factored in a European systemic risk Scenarios Relative performance: carry trade versus value strategies (01.01.2008 = 100) 110 100 Growth at potential 90 80 Mild growth 70 European systemic risk 60 Mild recession Global systemic risk 50 Deep recession 40 08 09 10 11 Buy SellIntensity of the macro scenario CAD, AUD, NZD, USD, EUR, JPY Carry trade NOK, SEK GBP, CHF USD, EUR, JPY CHF, CAD, AUD, Value GBP, SEK NZD, NOK Source: AA&MR, Datastream Pictet Secular Trends Year 3 - Strategy 2012 47
  22. 22. Pictet’s equity barometer: market factored in a European systemic risk Scenarios Stoxx Europe 600 Growth at potential 310 290 Low volatility Mild growth 270 250 Medium volatility European systemic risk 230 Mild recession 210 High volatility 190 STOXX EUROPE 600 E - PRICE INDEX Global systemic risk 170 Deep recession 150 10.08 10.09 10.10 10.11Intensity of the macro scenario Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 48
  23. 23. Bonds: 10-year bond yields fell heavily in Q3 before reboundingDue to a high core inflation rate, our fundamental model is still pointing to a fair value of 3.7%US Treasury 10-Year bond yield and model estimates 10-Year US Treasury yield and directional pressure % 6.00 100.00 9 90.00 5.00 8 10-year bond yield 80.00 70.00 December 2011 7 4.00 60.00 Systemic 6 Model* risk 3.00 50.00 premium Insert here your graphs and tables 5 in a high 40.00 volatility 2.00 regime 30.00 May 2012 4 20.00 1.00 3 10.00 *Based on short-term rate, core inflation, 2 0.00 0.00 economic growth and budgetary deficit 06 07 08 09 10 11 12 13 1 US 10 Year Note Yield 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Directional Pressure Index 0 - 100 (leads 19 months) Source: AA&MR, DatastreamPictet Secular Trends Year 3 - Strategy 2012 49
  24. 24. Perspectives on-lineStay in touch with our blog:http://perspectives.pictet.coma constant flow of information inasset allocation, macro research,and competitive insights. Read Download SubscribePictet Secular Trends Year 3 - Strategy 2012 50
  25. 25. Disclaimer: This report is issued and distributed by Pictet & Cie based in Geneva, Switzerland. It is not directed to, or intended to be used by, any person or entity that is a citizen or resident of, or locatedin, any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation.The information and material contained herein are provided for information purposes only and are not to be used or considered an offer or solicitation to subscribe any securities or other financialinstruments.Furthermore, the information and estimates expressed herein reflect a judgment as at the original date of publication and are subject to change without notice. The value and income of any of the securitiesor financial instruments mentioned in this document can go up as well as down. The market value may be affected by changes in economic, financial or political factors, time to maturity, market conditionsand volatility, or the credit quality of any issuer or reference issuer. Furthermore, foreign currency rates may have a positive or adverse effect on the value, price or income of any security or related investmentmentioned in this report.The trade instructions and investment constraints set forth by the client shall take precedence over, and may diverge from, the bank’s general investment policy and recommendations.Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty expressed or implied is made by Pictet & Cie regarding future performance.Portfolio managers are granted a certain degree of flexibility so as to accommodate the individual wishes and particular circumstances of clients; as such, the asset allocations specified in this report do nothave to be strictly abided by. Actual allocations to alternative, non-traditional investments (e.g. hedge funds) may exceed those mentioned in the grids herein provided that traditional equities are adjustedaccordingly. www.pictet.comPictet Secular Trends Year 3 - Strategy 2012 51

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