Didier Saint-Georges
Member of the Investment Committee
The need to restructure the Cypriot banking sector has been inexorable after the collapse of Greek public debt, to which it is closely connected. It presents an excellent opportunity for the European Union to set a limit on how much moral hazard it will accept. The punishment is harsh, but is the solution of sharing the pain with private creditors of a eurozone country’s banking sector – depositors – not justified when these depositors are mostly non-resident, the banking system is based on an offshore model, the country is just as insolvent as its banks and its economy accounts for 0.1% of European GDP? In any case, the markets think so: for the time being, interbank lending has seen no significant increase in stress within the eurozone. The contagion volcano has remained dormant and the European Central Bank’s watch has been remarkably quiet. And yet the Cypriot crisis has confirmed that the eurozone’s crisis resolution model remains highly chaotic. This is hardly reassuring when Italy’s political deadlock has once again raised the issue of conditional ECB support. And with each passing day, the worsening of the European economic slowdown delays the prospect of the eurozone’s southern countries reducing their debt that little bit further (see our March 2013 letter, "All you need is growth"). These events placed an even heavier burden on Europe in the first quarter. However, the bid to eliminate systemic risk since last summer has overcome its first hurdles. This ultimately means that we should be looking at what is now happening – frequently out of necessity too – in the United States, Japan and China.
The substantial levy on cash deposited at Cypriot banks (even limited to amounts of more than €100,000), on top of capital controls introduced to the country, sets a frightening precedent.
The prospect of a temporary technocratic government in Italy also suggests a freeze on the reforms undertaken by Mario Monti. These developments make the eurozone horizon a little darker still. However, they do not seem to justify a significant increase in risk aversion over the short term. This is partly because such a loss of confidence would mean ignoring the adjustments made in southern Europe’s larger countries (despite the recession, Italy’s fiscal deficit is now below 3%), and partly because the markets know that, if necessary, Mario Draghi will not hesitate to offer banks enough liquidity to prevent mounting pressures, similar to those of spring 2012. In contrast, the Cypriot crisis makes us even more sceptical about the European banking sector’s ability to accelerate lending to businesses. Indeed, already shackled by the need to reduce debt, Basel III constraints and weak demand for credit, European banks are now threatened with a decrease in their deposits, which customers may now wish to keep to a minimum, worried about the Cypriot precedent. Quite clearly, the prospect of a eurozone economic recovery in the second half of 2013 is weakened further by this new thorn in the banking industry’s side, especially as the eurozone’s second largest economy, France, is starting to slide into recession without any convincing solution in sight.
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IN THE EMERGING WORLD...
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...China’s change of leadership raised a number of concerns among investors. Added to what was still a global economic slowdown less than a year ago, these apprehensions resulted in a mediocre performance for the Chinese equity market and emerging markets in general. Should we be worried? We first have to realise that in India as in Brazil, the debatable quality of macroeconomic management (political intervention in Brazil and inability to pass reforms in India) has not affected investment opportunities. The simple example of infrastructure requirements in the two countries raises the possibility of well managed private enterprises generating quite remarkable earnings growth despite virtual stagflation in the case of the Brazilian economy and a balance of payments deficit in the case of India. In China, the macroeconomy is more decisive for investors. What does it tell us? Essentially, it shows that immediate economic growth will be safe while the Chinese authorities undertake the extensive reforms needed. The new leadership has forcefully reaffirmed the two key priorities for the medium term, aimed at improving the “quality” of economic growth, and is getting to grips with them. Firstly, increasing the return on capital expenditure by shifting the funding effort to the private sector. This objective underlies the programme to deregulate the financial sector even if it is damaging for the banking industry in the short term. Secondly, supporting growth in household income and consumer spending. The lever for this is the continued urbanisation of the economy through the reform of the Hukou system. Meanwhile, the short-term need to stay on track for sufficient economic growth is being met, without reviving inflationary pressures, especially in the property sector. Striking the right balance is certainly tricky. However, our recent visits to China have reassured us in our view that the economy will post a growth rate of at least 7% over the next few years while essential qualitative adjustments continue to be made. In the immediate future, the ongoing recovery in the United States will obviously provide an additional source of economic performance for China.
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IN THE UNITED STATES...
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... as we predicted in our January letter (“What will politicians do about the economy?"), the upturn in the investment cycle continued in the first quarter with consumer confidence robust despite an increase in the tax burden at the beginning of the year. Resilient domestic consumption driven by the property sector pick-up, steadier growth in emerging market demand (Chinese retail sales continue to rise by 12% a year) and the Japanese recovery are all lending support. Statistics published at the end of March suggest slightly less buoyant activity. So in the second quarter, we will have to check that the US recovery does not lose momentum despite the negative impact of the European recession.
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IN JAPAN...
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It is, of course, too early to judge the effectiveness of the economic and monetary programme announced by the Japanese Prime Minister, Shinzo Abe, and the governor of the Bank of Japan, Haruhiko Kuroda. Our investments in this theme, made in Japanese equity markets as of late 2012 and fully hedged against a weakening yen, have already been highly profitable. The policies announced are certainly radical, but made necessary by the level of Japanese public debt, which is unsustainable in the absence of growth and inflation. As such, we believe the authorities in Tokyo will remain intent in their pursuit of the measures announced.
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THE GLOBAL ECONOMIC LANDSCAPE HAS THEREFORE BEEN VERY MIXED IN EARLY 2013.
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One of the major benefits of the reduction in systemic risk since last summer has been the weaker correlation between asset classes. Individual economic performance in each region can now be reflected accordingly on the markets. Whereas the level of correlation between developed and emerging markets was still around 73% in 2012, it is now only 27%. Between developed markets themselves, the correlation has fallen from 47% to 28%. Between emerging markets it has loosened from 41% to 19%. This change is decisive. While it does not remove the need for tactical fund management, being highly responsive to changes in the European situation, it nevertheless justifies diversified, global fund management more than ever.
Euro weak again
The Italian political deadlock and Cypriot crisis have dealt a heavy blow to the euro, which dropped further against the US dollar, reaching its lowest level since last November at 1.2751. However, this reaction also comes at a bad time for the euro: expectations of a growth differential of more than 3% in the first quarter of 2013 and a long-term interest rate spread of 60 basis points in favour of the United States, a historically rare level. Our dollar exposure has been increased to 70% in Carmignac Patrimoine and 77% in Carmignac Investissement. We have maintained our full hedging of the yen ahead of the Bank of Japan’s next meeting at the beginning of April, which should bring measures to step up the asset buying programme, one of the effects of which will be to decrease the value of the yen.
Pressure on peripheral countries’ yields and on credit
Although Spanish government bond yields have been able to withstand the pressure on Italian sovereign debt, they have been affected by the broader general distrust following the collapse of Cypriot banks. Carmignac Sécurité’s and Carmignac Patrimoine’s fixed income portfolios have suffered a little from wider government and corporate bond spreads during this period of risk aversion while at the same time Carmignac Capital Plus has benefited from its various performance drivers against a backdrop of volatile yields. However, we think this chapter will end with a stricter ranking of issuers, benefiting our positions, which are concentrated on the highest ratings. Our portfolios’ modified duration has been kept at modest levels with US and German government bond prices already high. At the end of March, modified duration stood at 3.19 for Carmignac Patrimoine, 5.74 for Carmignac Global Bond and 2.06 for Carmignac Sécurité.
US and Japanese markets continue to rise
The US market differed from European markets with a 3.6% gain over the month, skirting on the S&P index’s highest level since 2007. Peripheral countries, to which our equity exposure remains low, suffered from risk aversion as well as disappointing macroeconomic results. The Japanese equity market posted a very respectable performance of 7.25% in March, reflecting investors’ growing confidence in Prime Minister Shinzo Abe’s reflation policy. Our global funds, Carmignac Patrimoine and Carmignac Investissement, duly increased their positions in the two zones in which current trends are most encouraging: the United States and Japan.
Investment themes to be rebalanced
While the market continues to hope – probably a little too optimistically – for a sharp upturn in demand for commodities, heavy burdens remain: the nature of Chinese growth, persistently mediocre global growth and high reserves. Faced with these troublesome developments, our funds have in recent months been refocusing their positions on natural resources enjoying stronger trends, such as energy – especially unconventional energy – in the United States, storage and transport companies, chemicals companies and refiners who are benefiting from significantly lower energy costs. Our global funds, Carmignac Patrimoine and Carmignac Investissement, duly sold their gold mining stocks on which the opportunity cost had become too high. Carmignac Commodities gained 0.23% over the month.
Asset allocation
Our funds of funds turned in positive performances over the period. However, exposure that was a little too cautious at the end of the month and a negative contribution from European portfolios prevented them from outperforming their reference indicators. Equity exposure stood at 36.9%, 25.8% and 17.9% for Carmignac Profil Réactif 100, 75 and 50 respectively at the end of the month. Carmignac Investissement Latitude’s exposure stands at 50.5%.
Source : Morningstar as at 21/12/2012.
Please note that past performance is not a guarantee of future returns and that it may fluctuate over time.
