efg quarterly review_q3 2013_lo res

8/14/2019 EFG Quarterly Review_Q3 2013_lo Res

1/12

Summer 2013

QUARTERLY REVIEW

This issue:

Flows and fundamentals

US:Data dependency

Europe:ECB activism

Asia:Chinas shadow banks

Special focus:Active fixed incomemanagement


2/12

EFG International

Comment

If anyone doubted the importance of central banks to the worldsfinancial markets, events of the early summer should lay theirdoubts to rest. The hint that the US Federal Reserve would taperits programme of asset purchases assuming that the US economy particularly jobs growth was strong enough sent markets intoa tailspin in June. Japan, however, is keenly embracing US-stylequantitative easing (QE) policies. And, in early July, the ECB

adopted the US approach of giving forward guidance on short-term interest rates. The Bank of England is thought likely to adopta similar approach.

So, although the precise details vary, the US model of post-crisismonetary policy seems to have been effectively exported to therest of the world.

Comparisons with the US, of a less favourable nature, are alsobeing made in China. Concerns about its shadow banking systemare being likened to the conditions which preceded the US sub-prime crisis. There are important differences, and we do not thinkthis is Chinas Lehman moment, but clearly Chinas bankingsystem will remain a source of concern for some time. Fixingbanks, the last five years tells us, is a slow process. For investors,however, much bad news already seems discounted in the Chineseequity market.


3/12

Quarterly Review Summer 2013

Overview

Contents

03Asset market

performance

04US: Datadependent QEtapering

05UK:Double dipdisappears

06Europe:ECB activism

08Asia:Chinas shadowbanks

09Special focus:

Active fixed

income

management

After more than four years of very easy monetary conditions in the US, financial markets arestarting to adjust to a different environment. However, the phasing out of expansionary policiesin the US will be a long, slow process and will be conditional on the strength of the economy itwill be data-dependent. Furthermore, other countries are only now embracing US-stylemonetary policies (QE in Japan and forward guidance on rates in Europe).

Expected changes in policy have led to some large fund flows, out of assets previouslyconsidered safe, such as gold, core government bonds and inflation-protected securities. Recentcapital losses on such assets have challenged the notion of their safety.

The summer is often a volatile time in financial markets and in that context such uncertainconditions may be expected to continue. This, however, is an environment in which a carefulassessment of fundamentals needs to be set alongside the short-term vagaries of fund flows.

Figure 1

2007 2008 2009 2010 2011 2012 2013

-120

-100

-80

-60

-40

-20

0

20

40

60

Index,

+=better/-=worsethanexpected

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

%

Citigroup Economic Surprises Index for major economies (lh axis)

US 10-year government bond yield (rh axis)

Economic

data better

than expected

Source: Thomson Reuters Datastream. Data as at 2 July 2013.

Economic

data weaker

than expected

Economic surprises and bonds

What sort of growth?

It is commonplace to describe economies as being at various

positions in their economic cycle recovery, recession and so on.

Such an analysis is, however, somewhat inappropriate in current

circumstances: different economies are better described as being

at varying stages in their post-crisis and structural adjustment.

In these circumstances there is a heightened sensitivity to data

releases. Better than expected data has typically seen the price of

safe haven assets, such as US government bonds, fall with their

yield rising.

The US is making a good recovery from its credit and housingcrises. Even so, economic growth still remains weaker than long-

run historic averages and the labour market is not yet strong

enough to support an early withdrawal of monetary stimulus. The

UK recovery lags that of the US but data revisions have seen the

double dip disappear and growth seems to have recovered well in

mid-2013. Japan has posted strong growth so far in 2013: probably

helped by Abenomics, at the very least with regard to the positive

influence on confidence. However, the jury is still out on whether

or not that set of policies will ultimately succeed in boosting

growth and eliminating deflation.

In the Eurozone, many structural challenges remain to be

addressed, austerity fatigue can be seen in some countries andthere is slow progress on the structural reforms which were

designed to bolster the Eurozone. Economic activity has, at best,

stabilised. China, meanwhile, continues to strive for a rebalancing

of its economy away from export and investment dependence and

toward more consumer-orientated growth. Growth is firm but the

perennial fears of a hard landing have not been dispelled.


4/12

EFG International

02

Figure 4Figure 2

2009 2010 2011 2012 2013

99

100

101

102

103

104

105

106

107

108

109

Index,

Q12009=

100

EurozoneUSJapan


GDP: Japan vs US and Eurozone

Figure 3

Source: JP Morgan, Thomson Reuters Datastream. Data as at 2 July 2013.

03 04 05 06 07 08 09 10 11 12 13

70

80

90

100

110

120

130

140

150

Index,

January

2003=100

BRIC Eurozone JapanUSN11*

Less competitive

*Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, Turkey, South Korea, and Vietnam

Real exchange rates

Source: IMF World Economic Outlook database. Data as at 2 July 2013.

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-10

-8

-6

-4

-2

0

2

%o

fGDP

Brazil India Turkey South Africa

Forecast

Current account balance: ten-year downtrend

Flows and fundamentals

Perhaps because economic growth does not yet seem to be

on a secure footing, indications that the US Fed may taper its

quantitative easing (QE) programme (that is, reduce then stop

its programme of asset purchases) have caused a number of

dislocations in financial markets.

As well as the impact on safe-haven bonds, fears of tighter

global liquidity have adversely impacted emerging market bonds,

currencies and equities that had been favoured in the hunt for

yield. Fund outflows from many of these previously-popular assets

have been substantial and, at times, disorderly. The drawbacks

of passive, index tracking investing for such assets have been

highlighted (see Special Focus on page 9).

Changing perceptions

In that context, a changed perception is, in some cases warranted.

Japan has long been regarded as a structurally weak economy with

entrenched deflation and poor demographics. We are cautiously

optimistic that the aggressive set of policy measures introduced by

the new government will have a positive short term impact on the

economy although the longer term implications are less clear. It is

notable that, even before these measures were introduced, the

Japanese economy had made a respectable recovery from early

2009 the trough of global activity.

In the emerging economies, we need to be mindful of the fact that

fund flows into these economies in recent years have had, in some

cases, a very distortionary effect. Notably, they have driven up

real exchange rates in a number of countries (for example Brazil,

India, Turkey and South Africa), impairing their competitiveness and

bringing a deterioration in their current account balances. Other

emerging economies have not been as adversely affected.

Although the importance of the emerging economies in driving

global growth on a long-term basis remains intact. Variations

around that theme also need to be considered.

We return to these themes after a discussion of recent asset

market performance.


5/12


US Europe Japan Emerging World

-15

-10

-5

0

5

10

15

20

%

Bonds, total return US$ terms

Equities, total return, US$ terms

Source: Citigroup (bonds); MSCI (equities). Data as at 2 July 2013.

Six months to end-June 2013

Figure 5

Asset market performance

03


In all of the main developed markets, equitiesproduced positive, and government bondsnegative, returns in the first half of 2013. In themain emerging markets, both bonds and equitiesposted losses in US dollar terms.


Overall world equities produced total returns in the first half of

2013 of 8.8% in US$ terms. The strongest performing countries

were Japan, with a gain of 16.6% in US$ terms and the US (up

13.7%).

Japans equity market the starperformer in the first semester

Equity markets

The four main emerging equity markets Brazil, Russia, India and

China all recorded losses in US dollar terms in the first half of the

year. In contrast, all the main developed equity markets returned

positive local currency returns, with Japans gains amounting to 34%.

Currency weakness against the US dollar undermined theperformance of almost all markets in dollar terms. That was most

notable in Japan, with a sharp fall in the yens value. Even so,

Japan still produced the strongest dollar-terms returns in the first

half. Australias gains in local currency terms were transformed

into losses in US-dollar terms as the currency weakened sharply.

Concerns about slowing Chinese growth and commodity prices

weighed on the Australian dollar.

Figure 6

Source: Citigroup. Data as at 2 July 2013.

Japan Australia UK Switzerland US Eurozone

-15

-10

-5

0

5

%

US$ terms

Local currency terms


Bond market returns

Figure 7

Equity market returns

Source: MSCI. Data as at 2 July 2013.

Brazil

Russia

China

India

Australia

UK

Taiwan

Germany

Switzerland

US

Japan

-20

-10

0

10

20

30

40

%

US$ terms

Local currency terms


Past performance is not an indicator of future performance.



Bond markets

Most developed world government bond markets recorded

negative total returns in local currency terms in the first half of

the year. Losses in capital value, as yields rose, outweighedcoupon income. In US dollar terms, as the dollar appreciated

against most currencies in the period, returns were further into

negative territory: losses in the Japanese government bond market

amounted to 12.4%.

Behind the back-up in bond yields was a concern about the effects

of a tapering of the US QE programme, which would entail a

slower pace of Fed purchases of government and mortgage bonds.


6/12

EFG International

04

United States

The health of the US economy will be carefullymonitored during the summer as the US FederalReserve has outlined that various economic criteriawill be carefully assessed when judging the timingand pace of the exit from ultra-low interest ratesand the scaling back and ending of quantitativeeasing (QE).

Tapering decisions

The importance of the US economy and monetary policy decisions

to the entire world was underscored by the fact that all globalfinancial markets were affected by recent Fed comments that it

would start to taper its QE programme.

Tapering refers to scaling back the Feds monthly asset purchases

from the current pace of $85bn. That is, the Fed will still continue

to buy government and mortgage bonds but at a slower rate.

Growth recovery

The fact that US GDP growth has recovered sufficiently well

enables such a step to be considered. In particular, the private

sector is regaining momentum, offsetting the drag on overall GDP

growth from lower government spending. As a result of the wayGDP growth data are reported - quarter on quarter annualised

changes - growth could well appear stronger in the third quarter

as comparisons are made with the second quarter (in which the

effects of government spending cuts were greatest).

Figure 8


2007 2008 2009 2010 2011 2012 2013

-6

-4

-2

0

2

4

6

Overall GDP growth

Federal, State and local government spending

Private sector spending

%c

hangeonyear

US GDP: government and private sector

Labour market is key

However, the most important economic information behind the

tapering decision will be labour market data and, more specifically,

the monthly change in non-farm payroll data. Over the first six

months of 2013, the increase averaged 190,000 jobs per month.

If that pace in maintained, we think it will justify a gentle taper in

asset purchases. If gains are above 200,000 per month a more

rapid taper would be warranted, but less than 140,000 per month

would signal no tapering. Importantly, gains at that rate are unlikely

to absorb all the new workers entering the labour market and theunemployment rate is likely to rise. However, the link between job

creation and the unemployment rate is far from direct as there has

recently been a steady fall in the participation rate (the share of the

population in work or actively seeking work).

The exit route from the USs unorthodox policies will certainly take

a long time and require a delicate balancing act.

Figure 9


2010 2011 2012 2013

63.0

63.5

64.0

64.5

65.0

65.5

%

7.5

8.0

8.5

9.0

9.5

10.0

%

Participation rate (lh axis)

Unemployment rate (rh axis)

US labour market

Trends in the labourmarket will be thekey factor behindthe tapering of theFeds assetpurchases.

Fed moves on monetary policyare data dependent


7/12


05

United Kingdom

There are some brighter signs with regard to the UKeconomy allowing the Chancellor of the Exchequerto claim recently that it is out of intensive care.

Economic surprises

In financial markets it is so often the case that economic data

are judged not in an absolute sense whether growth is positive

or negative, for example but relative to expectations. It is the

surprise element which influences financial markets. In the UK

recently those surprises have been generally favourable, with data

better than market expectations.

Revisions to past data on GDP have also helped dispel some of

the gloom. The double-dip recession the renewed drop in output

in late 2011/early 2012 after the recession in 2008/9 no longer

exists, thanks to such revisions.

Even so, UK GDP in the first quarter of 2012 was still 4% lower

than at its peak four years earlier.

Figure 10

2007 2008 2009 2010 2011 2012 2013

-80

-60

-40

-20

0

20

40

60

80

100

120

Index,+=better/-=worsethanexpected

UK Citigroup Economic Surprises Index


Economic

data weaker

than expected

Economic

data better

than expected

UK economic surprises

Figure 11


1980 1985 1990 1995 2000 2005 2010

25

26

27

28

29

30

31

32

33

Millions

UK total employment (millions) Recessions

UK employment

The UK produces more jobs,even in hard economicconditions

Labour market

Nevertheless, the UK economy has been good at creating jobs.

Numbers in employment reached a new peak of 32.3million in

the first quarter of 2012. The unemployment rate of 7.8% is similar

to that in the US. Employment levels fell only modestly in the

recession by 2.5%, compared with 7% in both the early 1980s

and early 1990s recessions.

It is true that many of the jobs created are part time and lower-paid,

but there is no doubt that conditions in the UK labour market are

much better than almost everywhere in the Eurozone.

Policy change?

This all means that when Mark Carney took over as Governor

of the Bank of England on 1 July, conditions were better than at

the time his appointment was announced in November 2012.

Nevertheless, his first comments highlighted that the back-up in

government bond yields could threaten continued growth and that

they were unwarranted by prospects for short-term rates. That, in

effect, amounts to forward guidance on policy interest rates.

UK equities

Although UK 10-year gilt yields have risen to 2.5%, they are still

low in a long-term historic context. UK equities, with a dividend

yield of 3.5% (on the FTSE All-Share index), continue to provide

attractive yield and total return prospects for longer-term

investors.

Double dipdisappears as dataturn more positive.


8/12

EFG International

06

Europe

In mid-2012 it was seen as essential to develop anew framework to strengthen the operation of theEurozone. Moves towards banking union and theuse of a common fund for bank recapitalisationwere deemed urgent. One year on, little progresshas been made on these issues.

Slow progress on structural issues

Perhaps most disappointing is the case of the ESM (European

Stability Mechanism), the eurozones 500bn rescue fund. This

was designed to be able to recapitalise banks directly. So far, that

has not happened: concerns about the collateral requirements

have been the main stumbling block and it is thought unlikely to be

operational for another 18 months.

Progress has been made on plans for banking union, entailing

common supervision of large European banks, but concrete

structures are unlikely to be in place for some time.

Some see the German general elections on 22 September,

because they distract German policy makers attention, as one

reason for the delay. Although President Angela Merkel is widely

thought likely to win, a new German government is unlikely to be

in place much before end-2013. By that time the direct elections to

the European Parliament (in late May 2014) will be looming. There

is a realistic chance that parties broadly opposed to current EU

policies will have a majority in that new parliament.


Germany France Italy Ireland Portugal Spain Greece

0

5

10

15

20

25

30

%

Unemployment rate, latest

Previous peak (since 1990)

Figure 13

Eurozone unemployment

EU leaders have

decidedthat when it

comes to fiscal and

economic integration

within the eurozone,

the decisions will be

taken at a later date.

Decision makingstalled

Figure 12

Eurozone economic surprises

2007 2008 2009 2010 2011 2012 2013

-200

-150

-100

-50

0

50

100

150

Index,+=better/-=

worsethanexpected

Eurozone Citigroup Economic Surprises Index


Economic

data better

than expected

Economic

data weaker

than expected

There are three main reasons for that. First, economic data have

been no worse than (admittedly low) expectations. Second, current

account deficits in the peripheral countries have narrowed sharply

or moved into surplus (to a large extent because of weak domestic

demand, which has curbed imports). Third, and most important,the ECBs pledge to do whatever it takes to save the euro last

July, the announcement of Outright Monetary Transactions (OMTs)

last September and the commitment to maintain interest rates

at present or lower levels for an extended period of time in July

have calmed markets. Mario Draghi has described the OMT as

probably the most successful monetary policy measure in recent

times, despite (or because of?) the fact that it has never been

used.

Although Eurozone equity markets have recovered since their

trough last June, valuations are still, overall, low and there are

many interesting stock-specific opportunities.

but a more active ECB

Despite these concerns, tensions in the Eurozone have subsided

and break-up risk is now considered a low probability.

Peter Spiegel,Financial

Times, 28 June 2013.


9/12


07

Could problems with Chinasshadow banks result in a hardlanding for the economy?

with limited transparency so cleaning up any problems posed

for the regulated banks by the shadow banks can be done more

quietly. Second, China still has strong economic growth, so to

some extent it can grow out of its problems. Third, savings levels

are high and banks themselves have not lent excessively the loan

to deposit ratio is only 75% whereas it was well above 100% for

US banks before the crisis.

For investors, the other major difference is that an equity market

bubble has not gone hand in hand with the growth of lending.

Indeed, the domestic Chinese equity market (the Shanghai Stock

Exchange A share index) is no higher than it was ten years ago.

In China, as in some of the other more export-orientated Asian

markets, we still see good value in equities.

Asia

Chinas shadow banks have been known to pose apotential problem for some time. Events in late June,however, propelled the sector into the spotlight.

Chinas shadow banks

The term shadow banking refers to three main types of financial

activity: off-balance sheet activity by the banks themselves;

activities of non-bank financial institutions such as trust and

leasing companies; and lending by retail money lenders to small

companies and individuals.

The expansion of credit by the Chinese shadow banking sector hasbeen rapid, trebling in size to RMB23 trillion in the four years to

the end of 2012.1The expansion of lending by the shadow banking

system has magnified the expansion of credit by the banks

themselves. The consequence has been that overall lending to the

private sector, which was stable at about 120% of GDP from 2003-

2009, has risen by a third since then.

Many see echoes of the USs credit crisis in Chinas current

problems. Growth of lending has financed construction spending

(infrastructure as well as housing); it has helped drive a surge in

property prices; some of the investment has been excessive

(building roads to nowhere) and, most recently, financial

institutions stopped lending to each other, with interbank interest

rates briefly soaring to 25%.

Even so, the parallels go only so far and we do not see this as

Chinas Lehman moment. First, banks are already state-owned,

Figure 14

China: bank lending to the private sector

Source: Thomson Reuters Datastream; Joe Zhang 'Inside China's shadow banking', Enrich Professional Publishing (2013).

2000 2002 2004 2006 2008 2010 2012 2014

90

100

110

120

130

140

150

160

170

%o

fGDP

Bank lending to the private sector

Bank plus 'shadow' bank lending to the private sector

Shadowbanking

Spotlight falls onChinas shadowbanks. But this isnot a Lehmanmoment.

Figure 15

China & Hong Kong: stockmarket indices

Source: Thomson Reuters Datastream; Hang Seng Indices (www.hsi.com.hk). Data as at 2 July 2013.

00 01 02 03 04 05 06 07 08 09 10 11 12 13

0

200

400

600

800

1000

1200

Index,

1

January

2000

=1

00

Shanghai Stock Exchange 'A' share index

(restricted to mainland China domestic investors and qualified foreign investors)

Hang Seng China Enterprises 'H' shares index

(mainland China enterprises with H-share listings in Hong Kong)

Hang Seng (main Hong Kong index)

1See Jo Zhang Inside Chinas shadow banking; the next subprime crisis? Enrich Professional Publishing (2013).


10/12

EFG International

08

Japan

Figure 17

Source: Thomson Reuters Datastream; EFG forecasts. Data as at 2 July 2013.

Corporate profits and forecast (Yen trillions)

2000 peak

2007 peak

2000 2002 2004 2006 2008 2010 2012 2014

2

4

6

8

10

12

14

16

18

20

Yen

trillions

Forecast

...but higher highs for profits

Figure 16

Japan: lower highs for the stockmarket

Source: Thomson Reuters Datastream. Data as at 2 July 2013

00 01 02 03 04 05 06 07 08 09 10 11 12 13

6000

8000

10000

12000

14000

16000

18000

20000

22000

Index

points

Nikkei 225 index

2000 peak

2007 peak

Japans stockmarket

has risen sharply

since Abenomics was

launched in late 2012

but it still offers good

value.

Strong profit growthin prospect

Although there has been a setback in the Japanesestockmarket after the initial sharp rise whichaccompanied the launch of Abenomics, we still seeit as cheaply valued relative to the trend in profits.

Abenomics and the stockmarket

It will be many years before the success or otherwise of the

set of policies known as Abenomics can be assessed. The three

arrows of the policy are: renewed fiscal stimulus, amounting to

13 trillion ($150 billion, about 2.7% of GDP); a 2-2-2 monetary

policy a doubling of the monetary base in 2 years to reach a 2%

inflation target; and a series of structural reforms to help improve

competitiveness. As a by-product of that set of policies, the yen

has weakened sharply.

The pass-through from a weaker yen to higher imported goods

cost has improved the outlook for inflation but reaching the 2%

target remains some distance away.

Furthermore, as noted above, Japans GDP growth since 2009 has

been on a par with the US and strong 2012 first quarter growth

was recorded.

The stockmarket has responded well to the measures with theJapanese equity market being the best performing developed

market in the first half of 2013, despite a setback after its initial

surge. It still remains, however, below the previous peaks recorded

in 2000 and 2007.

Corporate profits rebound

Corporate profits, however, have already risen and are generally

expected to grow strongly this year, to some extent as a result

of the yens more competitive level. A new peak level for profits

in 2013/14 looks a realistic prospect. Indeed, on the basis of

consensus twelve month forward earnings expectations, Japans

equity market is no more expensive now than it was in late 2012.

Scepticism questioned

Perhaps because Japans equity market has been such a poor

performer for such a long period of time, and because Japans

economy has repeatedly disappointed, scepticism about Japans

prospects is widespread. For the short term at least, we are taking

a more optimistic view with regard to the outlook for Japanese

equities.


11/12


09

At the start of the year we were concerned that there was little

value in many government bond markets that were viewed as

safe. We were concerned that many investors in such bonds were

not paying adequate regard to the risk of a rise in yields and the

consequent decline in capital values.2 That risk has materialized,

with 10-year US Treasury yields rising from 1.72% in late-December

2012 to 2.50% in early July 2013. That has brought an almost 7%

fall in the price of such bonds. Safe bonds have been far from

safe.

The sell-off in government bonds has seen other bond markets,

such as emerging market bonds, weaken as well. That is

unsurprising given that such bonds typically trade on the basis of a

yield spread over Treasury bonds, which act as the benchmark.

The announcement that the US Federal Reservewould start tapering its purchases of fixed incomesecurities under its Quantitative Easing programmeled to a sharp sell-off in many fixed incomeinstruments around the world. Flows out of manybond funds were substantial. The experienceemphasises to us the importance of active fixedincome management and underscores the problems

of passive, index-tracking investing in this market.

The advantagesof active, ratherthan passive,fixed incomemanagement.

Special focus:

Active fixed income management

Figure 18

Emerging market bond spreads

Source: EFG. Data as at 2 July 2013.

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

0

2

4

6

8

10

12

14

16

Emerging market bonds yield spread over US Treasuries

(based on actual historic weights in Emerging Markets Bond Index)

Spread based on current weights in EMBI index

Basis

points

The sell-off demonstrates to us one technical drawback of

investing in fixed income instruments via a passive fund. Such

passive funds seek to replicate the behavior of one of the widely-

used fixed income indices, but they failed to do so. The outflow

of funds was so substantial that, on an intra-day basis, they often

traded at a discount to the underlying value of the bonds held inthe funds. Essentially, the problem is that the liquidity offered to

investors in the passive fund was greater than in the underlying

investments. Funds tracking the index failed to do so with the

precision that investors expected.

Additionally, and more fundamentally, we remain skeptical of the

merits of such passive investing in fixed income markets. In bond

indices, a government or corporate issuer has a larger weight the

more debt that is outstanding. That means a greater amount is

invested in poorer credits.

Our approach to active fixed income investing is to focus on

fundamental value. That is the philosophy behind our EFG NewCapital Wealthy Nations Bond Fund*, for example. The emphasis

is on investing in bonds issued by countries which have strong

national balance sheets and external asset positions. In turbulent

conditions, as seen recently, our active management allows us

to reposition toward bonds that have underperformed due to

technical, liquidity and flow-related developments. Investors, such

as ourselves, with the focus on longer-term structural factors can

benefit from such an environment.

2See EFGs Quarterly Review, 2013 Q1Investing in safe government bonds.

* The value of your investment may fall as well as rise and you may not get back your original investment.


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efg quarterly review_q3 2013_lo res

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