Financial markets: hedging against new structural risks and stagflation

There are at least four new structural risks to consider: regulation, Middle East, euro zone’s crisis, and again the idea of a change in growth model of emerging countries.

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The first quarter of 2011 goes to its end and it is high time to review our assets allocation program in order to provide the best hedging to financial market risks

I do believe that our markets positions need to be in line with our views, our speeches and written statements (especially when we have strong convictions)

The analysis and understanding of macroeconomic and microeconomic fundamentals are now almost anecdotal compared to the stakes of new structural risks when it comes to forecast, hedge investments and optimize the management of the balance sheet.
Mory Doré

Thus, I took advantage of this first quarter

-To sell western countries’ large market cap (primarily in banking and insurance sectors) while holding a little bit more some high dividend stocks or potential special situation stocks

-To sell my government bonds (not the PIGS ones as I had any) of countries supposedly, wrongly or rightly, the safest in terms of fiscal solvency (French OAT, German Bund, UK Gilt, U.S. Treasury...)

-To not reallocate right away to emerging markets even though these assets should relatively outperform fixed income, equities and currencies of the OECD geographical areas. We shall come back on this point

-To hold defensive corporate bonds, including investment-grade bonds (i.e. up to BBB-) and speculative-grade bonds.

-To continue to strengthen allocation to real assets (real estate, tangible assets...) and financial assets benefiting from the decline in real interest rates and / or higher inflation:

  • inflation-linked bonds that we have just started to carefully select
  • then commodities rather as a socially responsible investment than as a pure speculative investment;
  • and finally tomorrow emerging assets

To sell simultaneously stocks and government bonds actually means to hedge against risks of economic stagflation (coexistence of economic slowdown and inflation), but it also means to hedge against the occurrence of four new structural risks.


First, there are risks related to the strengthening of prudential regulations (Basel III for banks even if its implementation calendar is spread over time; Solvency II for insurance). We have been writing for a long time now that these future developments will sustainably and negatively affect the performance of equity markets: On one hand we have a forecasted low demand for equities by institutional investors as these assets will lead to high capital consumptions. And on the other hand we have a forecasted increase in supply and thus the issues of stocks (in banking and insurance sectors but not only) related to the needs of increasingly large recapitalization.

We should monitor the change in agricultural commodity prices, which is a leading indicator of social and political risks in the emerging world ... and also the change in energy commodity prices for assessing risks of structural stagflation in the western countries
Mory Doré


Second, there are geopolitical risks related to protest movements and popular aspirations in the Middle East today and in sub-Saharan Africa tomorrow. These movements are not transient as they reflect the questioning of economic development models and autocratic political systems in a context of soaring food prices. This geopolitical instability that affects oil zones leads naturally to a fear the risks of stagflation in the West: imported inflation without second round effects so far via wage increases, reduction of the purchasing power of consumers likely to weigh on GDP.

We should not underestimate the risks of food crisis in some emerging economies. This risk exists particularly in countries that do not have an effective supply of grain and whose weight of food in inflation is very important.

Some statistics recouped here and there in OECD and IMF publications are frightening. Indeed the weight of food in the prices index of some emerging countries is simply amazing

  • In Africa, for example, that weight is 56% in Egypt (66% including energy prices), 36% in Tunisia (43% including energy prices) and 44% in Algeria
  • Amongst the poorest Asian countries, we have a weight of 40% in Pakistan and 58% in Bangladesh
  • Food riots might also occur in the most advanced countries among the emerging economies of Asia. The weight of food in the CPI (consumer price index) of some of these countries is significant: 33% in China, 26% in Hong Kong, 26% in Taiwan, 46% in India, 31% in Malaysia, 50% in The Philippines.

This is enough to monitor closely the change in agricultural commodity prices which has become a leading indicator of real social and political risks in the emerging world. Without mentioning to monitor also the change in energy commodity prices for assessing risks of structural stagflation in the western countries.

Even if we do approximately know how to assess the need for cash related to loans repayment of peripheral countries of the euro zone, we do not precisely know how to estimate the needs for recapitalization of the banking systems of these states.
Mory Doré


Third, the risk of implosion of the euro zone (we are currently finalizing a detailed study on this topic). Certainly we have been witnessing the establishment of more or less credible mechanisms and institutions in order to rescue countries with the most fragile budgets of the zone: strengthening of the European Financial Stability Facility (EFSF), support from the IMF, creation of a real European monetary fund: the European Financial Stability Mechanism (EFSM) which will replace the FESF in June 2013.

The issue is related to the fact that even if we do approximately know how to assess the need for cash related to loans repayment of peripheral countries of the euro zone, we do not precisely know how to estimate the needs for recapitalization of the banking systems of these states.

And beyond these assessments, we must recognize that the implementation of these structures will only help to solve the liquidity issues of these states over the next three following years (from 2011 to 2013), but in no case the structural issue which is a crisis of structural solvency (which is itself related to the sectoral specialization of countries that will not, given their current situation, ever generate trade surpluses).

We naturally worry about the dramatic Japanese context ... but we should also consider strong structural changes in the economic model of emerging Asian countries in general and China in particular
Mory Doré


Fourth, there are risks linked to the behaviour of Asian investors relative to their savings. It is probably the most worrying risk with regard to the balance of the international financial system

We naturally worry about the dramatic Japanese context. We know from the Japanese Ministry of Finance’s official sources that the Japanese net investment abroad was estimated at 3000 billion at end of 2009, including $ 1,300 billion investments in financial assets. More than 90% of portfolio investments in 2010 were for corporate or sovereign bonds. The purchases of U.S. sovereign bonds accounts for the lion’s share of these new flows with a total of nearly 160 billion dollars. We do understand now the tremendous risks faced by the U.S. bond market if the Japanese savings is recalled to cope with significant reconstruction needs still poorly assessed. Given this situation, the reallocation done by the world’s most credible bond management team, the PIMCO’s team headed by Bill Gross, only increases the risks of a bond crash in the U.S. and ultimately by correlation the crash of UK, French and German bond market .

But we should also consider strong structural changes in the economic model of emerging Asian countries in general and China in particular. Of course we do not expect the change in Chinese exchange rate regime to occur tomorrow. Thus, the current situation of accumulation of foreign exchange reserves achieved by issuing currencies to sell against dollar and euro while purchasing government securities denominated in those currencies could last for a while and therefore delays the rise in long-term rates. But we know that we must begin to seriously anticipate the change in Chinese growth model based on exports by a model based on domestic growth; When those days will come, the capital recall from China and emerging Asia will increase even further the sharp upward adjustment of long-term rates on both sides of the Atlantic ... I think those days are no longer that far

What about fundamentals? Are they still useful to forecast major directional trends? By fundamentals we mean here macroeconomic fundamentals: GDP revisions, confidence index like PMI in Europe and ISM in the U.S., job-creation or retail sales statistics, leading indicators on the state of consumption and therefore growth prospects. But we also mean microeconomic fundamentals with the earnings prospects of companies
At the risk of shocking any newbie or experienced economists, the analysis and understanding these fundamentals are now almost anecdotal compared to the stakes of the structural risks described above when it comes to forecast hedge investments and optimize the management of the balance sheet.

In the best case, the analysis of fundamentals will provide help for short-term trading bets. Moreover, this analysis could lead to investment strategies and medium-term / long-term hedging if and only if it significantly impacts the monetary policy of central banks. Yet, we know now that this monetary policy will just be adjusted at the margin in the Euro zone by the ECB (either one or two increases of 0.25% of REPO before realizing in early summer that it was probably a mistake); we also know that Anglo-Saxon central banks, FED and BOE would maintain their current policy for a while despite statistics related to the pseudo-strength of the U.S. economy and inflationary pseudo-pressures in the UK.

All of this argues for strong bets on steepening or /and end of flattening yield curve, especially in the euro zone with the purchase of 2-year maturities (too heavily penalized in recent weeks by exaggerated expectations of monetary tightening by the ECB) and the sale of 10-year maturities (in order to get a protection against beginnings of a bond crash)

We cannot conclude this paper without inferring medium-term directional bets on currencies

  • Naturally, we must anticipate a structural weakness of "major" currencies like the U.S dollar, euro and sterling against several emerging currencies
  • We shall bet also on the persistence of the strength of currencies like the Swiss Franc (risk aversion and geopolitical risk premiums) and Yen (risks of recall of savings)
  • In a context of structural assessment of commodity prices, so-called "commodity" currencies would naturally strengthen (we mean here Australian dollar, Canadian dollar and New Zealand dollar) against the U.S. dollar even though today it is better to wait for a technical correction of these currencies given their recent bullish path

The "major" currencies - U.S dollar, euro and sterling - are doomed to a weakening for distinct reasons: the U.S dollar in anticipation of losing its status as a reserve currency and the increasingly high difficulty to finance U.S. deficits; the sterling due to a sustainable weakening of the UK economy and here also difficulties to fund the structural trade deficits; finally the euro given the real risks of questioning the current operation of the euro zone. The point is therefore to know how these currencies will behave against each others

  • The observation of current deficits and above all their financing is rather bearish for currencies like the dollar and sterling, but probably more for the sterling as the currency, unlike the U.S dollar, has no international currency status. We forecast a return of GBP / USD in the range 1.50 - 1.53 by the beginning of the summer (low of the end of 2010) against 1.59 -1.63 today
  • Despite the persistence of an accommodative monetary policy in the United States and in the Euro zone, we remain strongly bearish on EUR / USD as the risk premium on peripheral debts of the euro zone will persist and intensify. Our target is a return to the range 1.26 - 1.30 (low of end of august 2010 and beginning of January 2011) by the beginning of summer 2011
Mory Doré March 2011

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