Many clients have been asking us for weeks now about the apparent inconsistency in our current thinking, based on our continued adherence to a mediocre macro scenario (L-shaped, for visual purposes) entailing strong risk that Europe will fall into a Japanese-style deflationist trap, which explains our longstanding enthusiasm for fixed rate government instruments, while maintaining our reluctance to propose frankly downward stock index strategies, instead limiting ourselves to put ladders or low premium ratios and advising against, for example, selling calls.
A side from purely ‘alpha’ considerations or the distortion in volatility (see my Stoxx volatility matrix from this morning), which make the sale of calls fairly unattractive in terms of risk/profitability and the dry puts which are a bit too expensive to carry, it is the power 0% interest rate motor that is drive this “prudence”.
Indeed, it would be a shame to deny us a little pleasure after we argued relentlessly for a steep cut in the ECB’s benchmark interest rates, to the chagrin of orthodox monetarists, when the central bank was still valiantly fighting the wrong fight, as it sought to counter the impact of rising oil prices, since their actions instead had the effect of depreciating the dollar and driving up oil prices…
If I write “0% interest rates” when certain benchmark rates remains slightly higher, it is because the more important rate in our scenario is the overnight rate, since it directly influences the profitability of risk-free money market funds, thus, creating a fabulous motive for investing in higher yielding assets, once the fear of Armageddon is over.
-- Like, for example, longer maturity government bonds, which help national budgets and stimulus plans, corporate bonds, which boost the fight against debt deflation, and equities, especially those which have been performing fantastically since March, thus putting the “annus horribilis” of 2008 fade from our memory.
A striking example of this favourable conjuncture is the “credit” market, corporate bonds where the rally has been so impressive (e.g. +40% since March 2009 on the High Yield segment in the
But they then find themselves confronted with the same dilemma as those who invested in “risk-free” assets: i.e. where to invest the generated liquidity?
As a result, they do not sell!
We see the same phenomenon on all risky assets, with the exception of commodity markets where prices always end up meeting fundamentals, unlike “paper” investments.
In this fluid context, as much we think it prudent to invest the limited premiums to protect stock market portfolios from a monthly correction of about 10 percentage points, we also think the more aggressive strategies, like the sale of calls, require such precision in timing and strike prices, that we prefer to avoid these moving sands for the time being – not because it is the easiest solution, but out of humility.
But then others ask: why don’t we try to ride the market rally and offer bullish strategies on stock market assets?
The answer is simple, given the numerous risks, which we are unable to quantify, but which seem to us to be sufficiently serious for us not to join today’s greed bandwagon:
- Exogenous shocks: by nature unpredictable, so why worry about them? However, who can tell how markets (and oil prices) would react to unilateral military strikes by
- The cost of financing for the “real” economy remains high, while inflation is at it historic lows. Despite our post commentaries about the sharp contraction in spreads this year, they remain historically high vis-à-vis government debt, and remain very expensive in real interest rate terms, given the economic situation.
- Uncertainty about the future of certain markets, like Mortgage Backed Securities and other securitisation instruments, once the help in the form of $1.45 trillion in Fed buybacks expires at the end of Q1 2010.
- Uncertainty about household consumption, which remains in de-leveraging mode, once the different government subsidies have come to an end, as illustrated by the end of the cash for clunkers plan in the
- Our main worry – a subject on which I feel increasingly isolated – is heavy deflationary trends, as exemplified by
The Nikkei has never really recovered from the lost decades.
Perhaps my isolation has something to do with the fact that I consider that an economy is in deflation once prices no longer rise at their minimum “natural” level, from 1.5% to 2% needed for lubricate an economy, and the feeling that prices and wages are showing growing nominally?
It is for this reason that I have attached a graph on the state of the situation, following the publication of German CP yesterday, and that of
In such a context, we prefer to maintain our asset allocation biases:
- Favourable to fixed interest rate instruments, with a now more favourable bias to the 5-10 year range,.
- On stock markets, we have returned to a negative bias after hitting our target range of 2850-2900 on the Eurostoxx, with, for example, the October put ladders. We did not advise an overly aggressive hedge strategy because the fact that indices rebound after each plunge highlights the persistent desire to invest of laggards frustrated by 0% interest rates.