Quarterly Report

Management report – 4th QUARTER 2015 Q4 2015


Economic analysis

Inflation remained flat over the quarter due to the further drop in oil prices, which reached 11-year lows in December. Yet after much hesitation, the US Federal Reserve raised its key interest rates by 25 basis points. As the global economy slows and liquidity dries up, the model relying on central bank intervention, which has been supporting the markets for several years, will be severely put to the test.

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Global view

Three months ago, we wrote that « despite six years of lax monetary policy, the global economy continues to suffer lacklustre growth and an inexorable rise in total debt. Weak activity and a lack of inflation raise the issue of how structurally sustainable global debt is at a time when the economy is showing signs of weakness in the United States. »

Since then little has changed, although the main reason for the lack of inflation was the further drop in oil prices, which reached 11-year lows in December.

Yet after much hesitation, the US Federal Reserve raised its key interest rates by 25 basis points. Does this mean that market players – rather complacently – believe in the new economic model orchestrated by central banks? Do they think that it will ultimately be capable of generating self-sustaining growth and the return to a self-sufficient business cycle?

As we wrote in our previous report, this belief “could be severely tested” early this year: if US growth were to soften during the normalisation of the country’s monetary policy, it would threaten the fragile balance that has been in place since 2009.

[Insights] 2015 Q4_Quarterly Report 1 EN


Recent economic trends in the United States have not weakened our scepticism over the strong growth expectations still generally held by the consensus. The Fed justified the key rate hike by citing a steadily improving labour market, robust investment and buoyant consumer spending. It also signalled that excessive leveraging in some segments of the credit market would have to be countered.

Equally, the wave of M&As and the volume of share buybacks indicate that credit conditions are offering financial engineering opportunities, sometimes at the expense of more productive investment. These potential bubbles call for preventative measures.

However, we do not share the Fed’s view of the US economy. Although the labour market is still improving, persistently weak wage growth reflects one of the lowest participation rates since the mid-1970s and a high percentage of part-time positions in job creation figures.

That said, the difficulty encountered by companies in filling qualified posts could end up pushing wages – and therefore cost-push inflation – a little higher, which would be even more problematic if oil prices were to stabilise.

Meanwhile, investment is flagging and will probably drop further, while corporate earnings – the best leading indicator of investment – were down 4% Y/Y in the third quarter. Growth in the capacity utilisation rate has fallen by 3% over a year, while leading indicators of industrial activity such as the ISM manufacturing index have returned to lows last seen in 2009. Inventory-to-sales ratios suggest production will slow, having risen constantly to reach a post-2002 high (excluding the Lehman Brothers crash), and annual industrial production growth was negative for the first time since 2009 in November.

Despite the massive boost provided by a 50% cut in energy prices to households – a repeat of which is clearly unlikely – consumer spending growth sits below 3%. The main factors that drive consumer confidence (annual real estate and share price increases) are fading. The recent strength of the property market has kept household savings rates very low (5.5%), but the observed loss of momentum will probably encourage consumers to save more.

We are therefore much more downbeat in our view of the US economy than either the consensus or the Fed. Our reservations about the US economy are nothing new: for the past six years, our early-year assessments have rightly been more conservative than the consensus. However, in previous years the exceptional level of monetary easing cushioned the impact of disappointing macroeconomic data on financial markets.

This time, our reading of the situation comes at a time when US monetary policy is normalising, meaning that if the slowdown that we are confidently expecting were to materialise, the market response would also return to normal. This downward adjustment could tip the economy into recession. But, to appear more credible, the Fed would have to let this risk grow before returning to a more accommodative monetary policy.

[Insights] 2015 Q4_Quarterly Report 2 EN

Emerging countries

Emerging countries are now more dependent than ever on oil prices, which have already shed 75% since their peak of March 2012. The export windfall for emerging countries is being hit by the lack of growth in world trade, the Chinese economy’s shift towards services and the United States’ lower dependency on energy imports.

Commodity producers are the main victims of slow global growth, but the entire international oil industry is also suffering from the crash. The financial position of numerous production companies, especially in North America, is clearly becoming ever more precarious, which is worrying given that it is an obvious source of contagion. This is reflected in the marked decline in the US high yield credit market as shale gas production companies - which had borrowed heavily to make some of the huge investments that are now contributing to the oil glut – experience severe setbacks. The deflationary logic now guiding the markets is particularly evident in the oil price drop prompted by heightened political tension between Saudi Arabia and Iran.

The markets are more worried about the growing difficulty that oil-producing countries are having in agreeing on production quota cuts than about a potential breakdown in supply due to possible diplomatic and military escalation between two of the world’s biggest producers at the heart of the Middle Eastern gunpowder magazine.

This prolonged oil price slump is sustaining heavy deflationary pressures, steepening the yuan’s descent against the dollar.

As the Chinese slowdown has come at a time of US monetary normalisation, the PBoC has been forced to unpeg the yuan from the dollar to stem capital outflows and ease downside pressure on the Chinese currency with a series of small devaluations.

However, the current level of depreciation (-6% vs the dollar since August) does not seem enough to restore confidence, and the PBoC reserves have dwindled by USD 100 billion in December alone. This makes a rate increase impossible given the debt burden of Chinese companies and the heights that real interest rates have already reached, meaning that devaluation looks to be the only feasible means of adjustment. This depreciation pulls other Asian currencies down with it, adding to the deflationary pressures of the oil crash on the global economy. As global trade has failed to grow for over three years, the emerging world is presented with a major challenge which so far does not appear to have been met.

India continues to stand out in this disparate group, helped by a (slow) economic reform policy, its farsighted central bank and, above all, its status as an oil importer. In contrast, Brazil, Russia and the Asian dragons are now suffering after having reaped the benefits of the commodity boom, global trade and Chinese economic growth.

But make no mistake : while China’s structural adjustment and the gradual liberalisation (however clumsily implemented) of its capital markets are currently making the rest of the world suffer, they are also laying the groundwork for a period of expansion that will attract international investors once the yuan has fallen far enough.

[Insights] 2015 Q4_Quarterly Report 3 EN
[Insights] 2015 Q4_Quarterly Report 4 EN


At first glance, Europe’s economic position seems more enviable. The region is benefiting from lower oil prices, its monetary policy remains accommodative, budget austerity is easing in some countries, and the euro is stable at a level that does not harm Europe’s competitiveness.

Leading economic indicators are mostly in the black, even if they are slipping a little, especially in Germany. The same trend can be seen for imports and exports. Southern European countries are continuing their gradual recovery, and France has now started to join them. However particularly high temperatures at the start of winter may have weighed on consumer spending and clouded the economic picture.

Nonetheless, the eurozone is not performing particularly well, with growth of just 1.6% and a very slight improvement to 1.7% expected in 2016. The contribution from investment remains sluggish, while consumer spending appears to be running out of steam.

Unsurprisingly, Europe is unable to shake off global deflationary pressures: annual inflation is just 0.2%, or 0.9% excluding energy.

The steady decline in European governance is also striking. After Greece, elections in Portugal, Spain and France revealed growing hostility towards policies to introduce reforms and clean up public finances. Angela Merkel, currently the linchpin of EU governance, has herself been under fire in connection with the refugee crisis.

Investment Strategy

The monetary policy reversal in the US was the novel factor that dominated the last quarter. This change in policy will keep risk assets under pressure by threatening to turn our projected US economic slowdown into a recession, amid fresh deflationary pressure from around the world and a liquidity dry-up. From an investment point of view, we believe that minimal equity exposure focused on high visibility companies will be the key, until the fear of recession forces the Fed to ease monetary policy again or leads investors to expect as much.

Top tier government bonds should benefit from the prospect of economic slowdown and deflationary pressure, even if prices are held back by monetary devaluation in the emerging world and the lower recycling of trade surpluses. Corporate bonds could suffer from poorer earnings prospects and scarcer liquidity. Further falls in the Chinese yuan will probably cause emerging market currencies to continue their slide. We have been selling the yuan in favour of the dollar. This provides at least some hedging against the negative effects of the global liquidity dry-up caused by this depreciation.

On the foreign exchange front, we are expecting the dollar to remain weak as the Fed appears increasingly less threatening in the short term. Going forward, if European growth disappoints and if the fears we expect materialise, it is likely that global flows will return to the dollar as a safe haven.

[Insights] 2015 Q4_Quarterly Report 5 EN