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May saw a continuation of the bond rally that started in mid-March as the European crisis lurched further towards the abyss. In the main developed markets bond prices have moved steadily higher over the last few months (our favoured markets of Germany and Australia were the strongest performers this month) while peripheral bonds suffered.

The moves in March saw yields hit new all-time lows within a number of markets and yet we remain pretty much max long in bonds here and are convinced yields have much further to fall. In terms of performance, we had another strong month in May with all funds significantly ahead of monthly targets. In fact, it was the strongest month since inception for our Pure Alpha Fixed Income Fund, a very pleasing result given the event risk dominating markets right now. Our internal tracking numbers indicate our Australian peer-group has had a rough couple of months, and now show us mid Q2 year-to-date and back at the top of the rankings on a rolling one-year basis.

At the risk of labouring the point we can't understand portfolio managers who run massive short duration positions relative to benchmark saying they are trying to preserve capital. In our view if you invest in a bond fund with an underlying benchmark (other than cash) you are asking your manager explicitly to manage to and hopefully outperform that benchmark as you want that negative correlation to equities the underlying beta provides you. If you wanted capital preservation you would put your money in an absolute return fund, leave it in the bank or even under your mattress. What that means is that we are singularly focused on generating outperformance against our mandated benchmarks, and hopefully the performance numbers we are generating will help to offset some of the losses on the other side of the ledger.

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Chart 1: US 10-year treasury yield

Source: Bloomberg

It’s always mentally tough in environments like these to manage bond portfolios; to run bullish positions, as we have done, means you are bearish on the global economy and will profit as the world suffers. A friend of mine said to me last week that outperforming in these conditions is like winning on the card tables on the Titanic – you are happy to be making cash but it's obvious that everything is sinking around you. In that regard I have always tried to be as pragmatic as possible: I try to control the things I can and let go of the stuff over which I have no influence. In terms of the long-run outlook, I am slowly turning Austrian. The more I look at the current world situation, the more concerned I am about the growing instability of the financial system and the reliance on money-printing to drive even modest growth. The death of the fiat-money system is something I once thought laughable but, in my humble opinion, as we continue to stagger through this crisis it is gaining more credence. No doubt you don't want to hear that. You want me to be upbeat and tell you equities are going to the moon and bonds have to sell-off, but unfortunately I can’t help you there.

Income & Fixed Interest commentary

May 2012

I was on the road visiting all the main centres with Crispin over the last couple of weeks on the BTIM Adviser Forum, which was themed ‘Equities & Bonds - Dangerous Liaisons’ (view our presentations). The key take-away for me was how much everyone hated my asset class. Most of the comments I received were something along the lines of “bond yields are so low that they have to rise and you are stupid not to see it” – I am paraphrasing here but not by much. For me the key point is that it's very easy to say something is expensive, but to expect it to cheapen without offering any reason apart from its ‘obvious expensiveness’ isn’t really an argument that I will use when deciding my investment positioning. I was always taught that an asset is never too expensive to buy nor too cheap to sell, i.e. something has to happen to change the trajectory of the price. And that ‘something’ is nearly always the medium-term supply-demand dynamic. Over the short term extraneous factors certainly affect pricing but the medium- to long-term driver of prices is always supply and demand. It is very clear to us that in bonds currently there is a massive supply-demand imbalance and that the pain trade is to much lower yields in the medium term. Obviously in the long term (ten years out) we agree that bonds offer little value, but in an environment like the current one, high-quality AAA government bonds remain the safest of safe havens, which goes a long way in explaining why they are in such high demand. To be clear I am not trying to be bullish bonds because I am contrarian by nature or trying to be different or even to try to make this Newsletter a more interesting read. I am bullish because it is what our process is telling me. Regular readers will know that the nirvana for us in terms of positioning is when our Core-Scorecard models line up with both our qualitative views and the technical input. This is exactly the position we are in now but we also have the added kicker of market positioning which is skewed against us thereby making the technical backdrop even more positive. In terms of our investment process it is rare for all four factors to line up so consistently and when they do we have to take note and run with the positions: for if not then, when? The key thing for you as clients though is the diversification we offer. If we are wrong and bonds sell off it is likely that equities are strong and therefore that your total portfolio will be performing well. If we are right and equities come under stress in the coming few months then your bond allocation needs to perform to help offset those losses. That doesn’t mean for one minute that we will be blindly long in a rising yield environment as our technical filters will take us out of our trades in short order. Ultimately you pay your money and you take your choice, for us the risk-reward screams in favour of long bond positions right now. So the pain trade is still for lower yields; It has been since February, probably even since August last year. May was a month punctuated by a surprising Greek election result and poor Chinese economic data which resulted in a massive 85bp rally in Australian 3-year bond yields. To put that number into perspective the average monthly move of the 3-year bond since the GFC began is less than 30bp. The move has been impressive, and our days don’t pass without another sell-side analyst expressing how the RBA “would never cut rates as implied by the

curve” and urging us to sell bonds or enter into curve flatteners (in this market – lazy shorts). This has been the same story for the past year, and despite every protest we heard about Australian bonds being expensive, they keep on getting more expensive, just as we have been predicting. Part of this attitude was a lazy home bias in terms of economic forecasting, another part was a favourable historical economic view on Australia given that it had avoided a technical recession during the worst of the crisis and, finally and probably most importantly, a strong belief in the continued growth of China and the mining capex story. This fundamental view can be partially excused because our own central bank pushed that line for a long period of time, even after the European events and a grab for safe-haven assets affected the pricing of our interest rate curve, to the point where it became very clear that things were worse than they thought. Two key things have now changed in this fundamental view. The global stock of safe haven assets has reduced markedly because of the mass downgrading of sovereigns all around the world, primarily in Europe. The second was the initial crowding out of the non-mining domestic economy due to a high Australian Dollar and slowing credit growth and then the gradual slowing of China and its effect on commodity prices. We have remained long Australian bonds throughout this entire period because of the expectation that imbalances in Europe would have an effect on Australia through the financial system and markets, and that China would unsuccessfully make the transition to a more developed economy growth rate. These are hardly viewpoints that point to the destruction of the world financial system even though we get branded with having this attitude. Being long bonds at this point in time does not mean the world will end. As long as we think the markets aren’t priced for the potential ramifications of what we envisage happening, then we will remain in this position. We haven’t expressed our viewpoint on Europe or China in any depth in a few months, opting instead to provide some thought on issues that aren’t as well covered. May saw the threat of a near-term Greek exit and Chinese slowdown come to the forefront and the story of these two economies is playing out in front of us, but there is further to go with simple economics being the undoing of both. Europe has again found itself at a crossroads. The Greek election early this month was under-priced in terms of the risk of triggering an early negotiation (I was going to say re-negotiation, but there was no negotiation in the first instance to speak of). New Democracy and PASOK (the pro-bailout, pro-Eurozone parties) couldn’t muster a sufficient majority after the unexpected performance of their main competitor, SYRIZA (anti-bailout, pro-Eurozone). The anti-bailout, anti-Eurozone parties weren’t significant enough to really challenge the more centre aligned parties. After several failed attempts to form a coalition from either side, eventually it was decided a second election would be held on June 17. Polls up until the end of the month are split between the two outcomes and varying interpretations are just making the market more volatile while not delivering any clarity. Again, this event risk is another reason why you should be holding bonds.

The election has been declared a vote on Eurozone membership but we are not really sure this is the case. We are convinced that Greece will have to forfeit Eurozone membership at some point in the future, with this election merely being a vote on whether that happens now or later. For the record we think there is a 90% chance of a Greek exit in the next six months. Due to the indecision of the Greek people and the Troika’s lack of patience with this, all cash disbursements under the bailout agreement have been suspended with the exception of cash for interest payments paid into the agreed escrow account. Since all Greek debt is essentially official debt post the PSI, the Troika are really just paying themselves. What isn’t being paid though is the primary deficit, i.e. the Government’s budget deficit excluding interest payments. This was forecasted to be a surplus for 2012 by Papademos and Merkel only eight months ago but the theme in Europe (most notably in Spain) that austerity plans rarely hit their intended targets continues here. The deficit has been reduced so far in the first quarter against 2011 but will likely finish the year somewhere between 1% and 2% of GDP, if Greece stays within the Eurozone. The problem now is that tax revenues have fallen off a cliff while in the limbo of a caretaker government and encouraged by the possibility of paying tax liabilities in a few months in a currency that’s worth only a fraction of the Euro held now. This means the funding requirement skyrockets while uncertainty prevails, and this has led the Greek Government to cancel the equivalent of the Pharmaceutical Benefits Scheme (among other things) until bailout payments resume. Not being able to afford your necessary medication is a quick way to send your vote towards the anti-bailout parties, even if the economic considerations aren’t fully understood by the electorate. In addition to funds provided under the terms of the bailout, Europe is offering another convenience to the Greek people in the form of a free put option of the value of their savings in return for the ability to boot the can down the road another time. Since Greece is still in the Eurozone, all banking assets and liabilities are still denominated in the Euro. As the probability of exit and the return of the Drachma increases, more and more people will likely get worried and move their savings cross-border to a German bank, or perhaps to the nearest mattress. In any other sovereign failure (Argentina in 2000 being a prime example) once this started happening, the banks would fail and the breaking of a fixed currency peg (in this case the Euro) would have to be brought forward and realised. As Bank of England Governor, Mervyn King, said recently: “it may not be rational to start a bank run, but it is rational to participate in one.” The banking system is the link between the likelihood of a country defaulting/breaking a peg increasing, and it actually happening. The TARGET2 (as it’s known) settlement system in the EU allows deposits to cross borders and any deposits that leave, for example, a Greek bank and make their way to a German bank are replaced with a deposit indirectly from the German central bank. This is great for banking stability because it means a bank cannot experience a bank run because deposit amounts are guaranteed. Wonderful! However all this means is not

only is Europe as a whole giving MORE money to Greece in addition to the bailout amounts, but it is actually giving money directly to those Greek people who are smart enough to move their deposits. Why? If we assume Greece is to leave the Eurozone and the Drachma is worth a fraction of the Euro (let’s say 50%, even though it will likely be much less than this) then the smart punters are getting 1 real Euro for every Greek Euro, instead of only 0.5. When the Drachma comes back these people will keep their existing wealth in Euros. But for every winner, there is a loser – and the loser in this case is the Eurosystem which gets to enjoy having all of its deposits turned into the Drachma, losing half of their value. The smart Greek depositor is having money given to them for the pleasure of the EU having their fixed currency live on. The ultimate FX trade. There is a lot of talk that deposit guarantees may be introduced to try and stem the flow of deposits from peripheral countries. Ignore this. Aside from the obvious question of who is actually going to pay for these guarantees, they do not address the problem at hand which is not about the solvency of the banks in the periphery (although this is clearly a problem) but that people are worried that their deposits are going to change from a Euro into a Drachma or a Peseta or an Escudo. No deposit guarantee will account for this, ensuring the continual flow of Euros out of the periphery. There are rumours of structured deposit guarantees that will even insure against a change in currency, but the chances of the Eurozone paying out insurance on deposits after a country has left the monetary union are almost non-existent, and depositors are realising this.

Chart 2: Target2 balances

Source: Barclays

It also seems that the number of smart people is increasing. The election has spurred deposit redemptions not seen since the crisis in Greece started. Forget election polls, or politicians rambling on. Unless Europe wants to be funding not only the government but the entire banking system of Greece indefinitely, something will have to give. European leaders will only want to keep kicking the can until an appropriate firewall has been set up between themselves and Greece, but the problem here is that, as with the austerity targets, the longer the reality is forestalled other problems – like Spain and Italy – make the firewall job even more difficult. The Eurobond (a bond issued jointly by all EU members to fund all countries within the EU) would be the ultimate time buyer if the periphery was able to restructure to become competitive again. Sadly the adjustments necessary are

immense, and the core is unwilling to attract more liability in such a transparent way that it is obvious to the electorate. This would help in the adjustment however – if the interest rate on this new Eurobond was the current average of all the individual country yields, Italy would save 2.4% of GDP per year and Spain 1.7%. A bigger winner would be Portugal, which would save 8.7% of GDP on new debt issued. Obviously the core would pay more, but it would go a long way to fix the imbalances as well as buy time. For the Spanish the threat of the return of the Peseta is in addition to a banking system that, outside the big two banks, is insolvent. The recent revelation of the recapitalisation requirement for Bankia (itself an amalgamation of 2 smaller failed banks) at €19 billion highlights the difficulty of having exposure to a still falling housing market that is far from a base. The Spanish government attempted to get the ECB to indirectly take the risk on this recapitalisation, as well as through some clever transactions to recapitalise the bank. This was denied by the ECB, and the resistance by Germany and Finland late in the month to the previous plan of using the ESM to help Eurozone banks, highlights the ongoing lack of interest in the core of taking the needed steps to share the debts of the periphery. With avenues for domestic bank recapitalisation closing, we expect a Spanish bailout will be a certainty in the near future. We have written about the non-competitiveness of the periphery versus the core on a number of occasions. This position came about due to Germany joining with an overvalued exchange rate which forced them to become extremely competitive during the pre-crisis years and this entrenched current account surpluses for Germany and deficits for the mostly non-competitive periphery. Since rates were accommodative and as they were catering for the low inflation environment in Germany rather than the strongly growing periphery, debt was cheap and plentiful. A current account deficit isn’t a problem unless it can’t be funded, so the great debt accumulation continued. Turning around a competitiveness problem in one year that has built up over the last ten, whilst also having a whole lot of debt to repay, isn’t an easy task. It’s almost an impossible one for Greece, and the problem isn’t too different in Spain. Spain was another country that had run current account deficits for the years leading up to the crisis. In fact the Spanish economy added 56% of GDP in debt in the years of 2000-2008 from current account balance data supplied by the IMF. Most of this was through the banks, with this debt funding a huge jump in house prices and a construction boom. The unwinding of this excess is incredibly painful. Spain however is large enough to pose a problem as the losses from an exit here would be too big for the system to handle. Restructure of the domestic economy is the only solution. This will mean falling wages and thus living standards for the Spanish people, with no domestic currency to help take some of the load. In this situation, if things don’t go right, Spain may not be able to leave, but the core may decide that they don’t want to pay. Instead of the weak leaving and trying to get their competitiveness up, the strong would leave to try and bring their competitiveness down through an upward currency valuation. George Soros realised how difficult it was for the UK to maintain this peg because of these

simple economic principles and bet against both the UK staying inside the ERM and the politicians who tried to keep the status quo. The same will likely happen here.

Chart 3: Current Account imbalance in Europe

Source: IMF

China was the other key theme for the month, and the

extraordinarily weak economic data super-charged

returns for Australian bonds. China is not too dissimilar

from Europe in that persistent imbalances during the

decade leading up to the GFC has culminated in a

situation where reversion to the balanced situation is

impossible without collapsing the economy. China ran

current account surpluses for all of this period by having

two things – a low cost base for manufacturing, and a

policy to hold down the value of the Yuan to make sure

that its competitiveness against Europe and the US

wasn’t eroded by a rising currency. Holding a currency

peg means accumulating foreign currency reserves

through printing the domestic currency. This depresses

domestic interest rates, causing all sorts of trouble when it

comes to investment. As a result the Chinese GDP is

nearly half investment. When economists talk of

“investment” they refer to the money spent on building

factories, equipment, infrastructure and housing and the

requirement for these things has been strong due to the

urbanisation of the Chinese workforce and strong export

demand. A bubble always needs a strong underlying truth

for it to perpetuate, and the urbanisation theme is a

strong one. There are many stories indicating the

imbalances caused by the currency policy have carried

on well past the effect of urbanisation, and the housing

market is now approaching that tipping point. The housing

industry in China is a primary driver of Australian

commodity demand and has large ramifications for us. It

was also 13% of total GDP in 2011 (being approximately

a quarter of investment).

Chart 4: China electricity output and GDP growth

Source: Bloomberg

Chinese real estate investment is still growing at an

extraordinary rate. The latest figures are still above 20%

growth from the year prior, however this has slowed from

growth rates above 35% as the economy emerged from

the GFC with big fiscal stimulus. These growth rates are

phenomenal, and apart from slowing slightly, show a

strong housing sector. When comparing against home

sales however, the picture becomes slightly more grim.

Chinese home sales are now contracting at a yearly rate

of sub 10% after plateauing at a 20% growth rate for most

of 2010-2011. This has caused developers to rush to

complete projects and get their properties out the door

before others do, causing a massive spike in completions

in the first quarter of 2012. This rush has caused pressure

on house prices with 67 out of 70 cities now experiencing

flat or falling house prices. The inventory of unsold real

estate is increasing, with the pipeline now approaching 36

months in duration. S&P has outlined that the property

developers it covers are becoming more financially

stressed as high leverage ratios are starting to bite. As a

result, land sales have collapsed by more than 50% in

April from the previous year. The provinces rely on land

sales for most of their revenue, and this revenue is

needed as most of the debt that funded the huge Chinese

fiscal stimulus from 2009 remains at this level of

government.

Chart 5: China real estate investment, home sales and

completion

Source: Bloomberg

This picture highlights that the unravelling is beginning. We have started to see Required Reserve Ratio (RRR) cuts to help stimulate credit growth which has also stagnated. Rumours of another fiscal stimulus package pledging greater infrastructure spending is the last thing that is needed as it will increase the imbalances further. We are aware that it is likely to have a positive impact on risk assets in the short run and we will manage our exposures accordingly. The inflation picture, closely correlated but lagged to credit growth, has slowed sufficiently to allow directed fiscal stimulus. A change in the leadership scheduled for late this year would increase the probability of such stimulus, especially if the universally weak data seen in May is the new trend. This slowing in the housing market is occurring simultaneously as China is moving towards running a current account deficit. Rising import prices coupled with slowing exports will result in capital eventually starting to flow out of the country, when the modern experience has been for current account surpluses and capital moving into the country. While a movement to a more balanced trade environment is good for competitiveness the world over, it would also mean China’s enviable $3.3 trillion foreign currency reserve would start being depleted and squeezing monetary conditions domestically. This may make China’s job to maintain the current growth rate even more difficult. More importantly though, it means that China will need to sell its stock of US treasury bonds, lifting US bond yields and de-railing the fragile recovery there. Will this mean more quantitative easing? If growth was affected we think yes but the bigger consideration for the US is if interest costs start climbing, then austerity – something they’ve been able to avoid – may come around more quickly than the market is pricing in. The run up in credit growth in most developed nations in the last 20 years before the crisis was a last dash, desperate grab for easy growth and wealth when all the traditional growth drivers (population growth and productivity) stopped occurring. The developed world has now found itself in a situation where the immense wealth generated over centuries of successful capitalism is getting more difficult to employ to make good returns, and as a result has led to this part of the world going ‘ex-growth’. The US and Europe are definitely there already, and the path of recent data suggests Australia may be heading that way as well. While we got away unscathed the first time around, that was with a starting point of a current account surplus. In this environment, deflation is the most likely outcome as demand growth softens. Many are worried about the printing of trillions in quantitative easing packages the world over affecting inflation in the near future. This is a real worry to be sure, but as long as the demand for credit remains as low as it is then the probability of this extra money making it into general circulation is limited, and it will likely continue to remain where it was initially created on the central bank balance sheet, not hurting anyone. Keep holding bonds as they will be your best investment, as growth and inflation remain lower than the consensus expects.

Vimal Gor Head of Income & Fixed Interest BT Investment Management

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