Carmignac's Note

The markets awaken January 2016

  • Didier SAINT-GEORGES - Head of Portfolio Advisors, Managing Director and Member of the Strategic Investment Committee

Market capitulation may present some exceptional entry points

Anesthetised by six years of ultra-loose monetary policy, the markets were generally able to continue ignoring economic reality in 2015 and remain focused on flows.

Owing mostly to the single currency’s depreciation, the European equity markets posted some of the world’s best market performances (in euro), despite the disappointing economic progress from this region.

Expressed in dollars, however, the European markets barely surpassed the very mediocre performance of the US S&P 500 (-0.7%) in 2015. With regard to bonds, the only investors to enjoy spectacular performances were those who gambled mainly on debt issued by Greece and Ukraine, which gained between 28% and 38% over the year, but also came very close to defaulting.

Nevertheless, the weaknesses we had previously identified last year in the wonderful world of central-bank-administered markets began to make an initial appearance. In 2015, it was impossible for investors to ignore the consequences for the equity and credit markets stemming from years of overinvestment in the US energy sector.

With central banks becoming increasingly restricted in their stimulus policies, 2016 is likely to be the year when the markets awaken to economic reality.

Collision course

These two pitfalls are now coming into view at the same time, which makes the central banks’ task all the more difficult: they are caught between the need to keep nominal interest rates very low and the need to maintain their credibility, after years of monetary creation, responsible for financial asset bubbles, poor capital allocation and widening social inequalities.

Central banks are starting 2016 caught between the need to keep interest rates low and the need to protect their credibility.

As such, a year after putting a stop to its quantitative easing, the Federal Reserve has just initiated its first cycle of monetary tightening since 2004, with the first signs of pressure on wages starting to appear.

And should energy prices eventually stabilise in 2016, inflation expectations might then well be reversed, compounding pressure on the Fed. In Europe as in Japan, central banks have started to baulk at the idea of further intervention.

At the same time, though, after six years of expansion, US manufacturing indicators have dropped to recession levels while spending on services has also begun to fall.

China is still slowing as well. The economic and interest rate cycles are set to collide. The monetary illusion is drawing to a close.

Safe haven in Europe?

A cyclical lag meant that Europe was one of the few places in the world to show economic improvement in 2015.

Even so, despite a 50% drop in energy costs, historically low interest rates and a 25% drop in the value in the euro,annual growth only reached about 1.5%, which is not enough to stabilise debt and kick-start employment.

And this performance was ultimately achieved at a time when the German powerhouse started to lose steam – loss of productivity momentum, decrease in profitability, exposure to the global cycle – and began to encounter its first political difficulties, namely tension in the ruling coalition over immigration policy.

As such, Europe enters 2016 in a fragile economic position, which in turn raises the issue of its political vulnerability, as the European project surely cannot afford to suffer a Japanese-style “lost decade”.

[Divider] [Management report] European flag

The emerging world: investors’ bogeyman

China, and in its wake the whole of the global economy, is still paying the price of the huge economic stimulus programme of 2008, which saved the country from catastrophic economic collapse, but only at the cost of excessive lending growth and a production capacity surplus that remains to this day.

The economic shift towards tertiary activity has already brought down commodity prices and affected the whole of the emerging world to varying degrees. However, it also makes many industries worldwide less profitable by contributing significantly to the global capacity surplus.

Much like the United States, but to an even greater extent, China is also facing the risk that it will struggle to fully protect its services sector from the effects of an industrial slowdown in 2016.

The Chinese authorities’ intention to stabilise this slowdown through accommodative monetary and fiscal policies will have to overcome the outflow of capital out of the country, which has become a steady stream since August, as well as bank balance sheets riddled with non-performing assets. To solve this tricky problem, China may well have to abandon its much trumpeted goal of maintaining a stable currency.

A substantial devaluation of the renminbi would ease its own economic burden, but hasten the export of its industrial overcapacity problems to the rest of the world, emerging and developed countries alike.

2016, or the year when markets awaken

Now that central banks have used up most of their options for intervention, and with the banking sector remaining inhibited by an extremely restrictive regulatory environment, investors will be in the front line to deal with heightened market risks.

At the same time, liquidity has dried up for all asset classes under the very influence of the central banks’ repeated intervention, making volatility spikes increasingly erratic.

As a result, when the high price of “risk-free” assets deprives said assets of their reliable safe haven status, risk management will require the use of very active, targeted hedging strategies. These will, in turn, make it possible to be opportunistic when market capitulation presents exceptional entry points for anyone who managed to keep a medium-term view.

Precursors of these developments are already visible in the oil sector and for certain emerging market assets, including bonds.

With the advent of these risks and opportunities on the horizon, in relation to which it will be essential to let go of investment habits that have served investors well for the last six years, the Carmignac teams and I would like to wish you an active, prosperous 2016.

Risk management will require the use of very active, targeted hedging strategies.

Investment Strategy

  • Currencies

    With the notable exception of the Indian rupee, emerging market currencies experienced another bout of weakness in December. This affected commodity exporting and importing countries alike, and should be viewed in the context of the US interest rate hike. Against this backdrop, our foreign exchange strategy’s preference for developed countries’ currencies and the hedging of emerging market currencies, especially the Chinese yuan, paid off. As the end of the year approached, we pursued a foreign exchange strategy that emphasised the euro, followed by the US dollar and, to a lesser extent, the Japanese yen.

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  • Fixed income

    During the month, the Federal Reserve decided to raise interest rates for the first time since launching its zero interest-rate policy at the end of 2008. Widely expected and accompanied by a very dovish tone regarding the pace of subsequent rate increases, this move did not exert any pressure on 10-year yields, justifying our positioning on this segment of the US yield curve. Although tension is mounting on certain bond asset classes such as US high yield bonds and emerging market sovereign debt, these segments have not yet capitulated, justifying even further reduced positions. We are therefore keeping a balanced, diversified allocation while keeping an eye out for the possible appearance of attractive entry points on high yield segments (for example, US high yield bonds are approaching 9%, while Brazilian 10-year sovereign debt yields already stand above 16%).

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  • Equities

    In December, equities continued the correction that began in November. Certain emerging countries, such as Brazil, experienced slumps amid economic and financial crisis. Meanwhile among developed markets, Europe posted one of the worst performances amid disappointment regarding the new monetary stimulus measures announced by Mario Draghi. During the month, we strengthened our positioning in less cyclical stocks by closing our position in cement maker Lafarge-Holcim. At the end of the year, hedging of the major global indices meant that our net exposure stood close to the minimum levels allowed for our funds.

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  • Commodities

    Despite a negative performance in December, our funds of funds fared better than their reference indices thanks to suitably defensive positioning. We remained cautiously positioned at the end of the year with moderate exposure levels and a defensive, balanced portfolio.

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  • Funds of funds

    Despite a negative performance in December, our funds of funds fared better than their reference indices thanks to suitably defensive positioning. We remained cautiously positioned at the end of the year with moderate exposure levels and a defensive, balanced portfolio.

    Background Carousel - Fonds de Fonds