Quarterly Investment Letter

Quarterly Investment Letter
2nd Quarter 2014
The Environment is improving but it does not
feel much like it
The optimism of market participants was exposed
to some stress test over the last months. Equity
investors were put back on a roller coaster with a
tough January followed by strong February and a
murky March (see the Market Data Table in the
Appendix for details). Key concerns were growing
worries about the Chinese financial system, the
conflict around the Crimea and very bad weather,
particularly in the U.S, which depressed global
growth expectations. Investors reacted by triggering sector rotation and profit taking. By the end of
the first quarter most developed equity markets
indices year-to-date were back in the black albeit at
levels below +2%. However, the performance of
the underlying holdings showed large variety.
Chart 1: Eurozone – Back to “Normal”
Source: GaveKal
The more critical assessment regarding China hit
the emerging markets and BRIC indices particularly
in January. Despite a recovery in February and
March these indices ended close to -3% for the first
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Highlights for Investors
The macro picture continues to improve
in the developed world. Inflation remains
low but deflation is not yet around the
corner although cause for some concern.
Investors’ optimism was tested in Q1 as
equity markets faced choppy price actions. But there is no end in sight for the
current “most unpopular bull market”
given continuing constructive fundamentals and no shortage of liquidity.
Sovereign bonds and credit of developed
markets outperformed equity markets in
Q1. Credit remains attractive while we
stay cautious regarding government
bonds’ exposure.
China’s financial system and its economy
will not collapse and investors will finally
adapt to lower growth rates. So far the
Ukrainian crisis has had no impact but it
might be a wildcard depending how the
involved parties will handle the situation.
These choppy price actions were quite difficult to
manage for equity long-short funds and eventdriven strategies as they got “whipsawed” or were
exposed to “short volatility”. In the first quarter,
hedge funds as a whole increased just above +1%.
Equity L/S managers were still able to perform by
+1.25% while Event Driven achieved even an increase of +2.8%. Increasing concerns on global
growth led also to a reverse movement at the yield
front. Yields at the long end started to decline
again and thereby interrupted the Fed-led “normalization process”.
This was helped by indications of the Fed to not
raise rates as quickly as previously anticipated by
the markets. The search for yield supported this
movement as more money flowed into the longer
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maturities. This came most likely from pension
funds which locked in higher yields of high-grade
bonds. Thus, US government bonds with maturities
above 10 years returned +6.5% in Q1. In contrast,
the maturities between 3 to 5 years returned zero.
For sovereign EURO bonds the respective returns
equaled +7% and +1.7% as the economic environment in Europe seems to constantly improve. It
is remarkable how confidence has returned as we
see spreads between “peripheral” Eurozone countries sliding back towards the levels of the more
robust Eurozone countries (see Chart 1).
China. Simultaneously, expectations of earnings’
growth in the developed markets have come down
with analysts being generally more conservative. In
fact, corporations which were able to improve margins through cost cutting, cheaper refinancing and
productivity gains in the past, must now rely on
simple top-line (sales) growth which is directly
linked to GDP growth.
Chart 2: The Expected Upswing of the U.S.
Loans have fared well, too, although gains were a
little muted as a consequence of new capital requirement rules for European banks affecting momentarily the loan market.
Overall, however, developed market bonds and
credit outperformed equity markets over the first
three months of 2014.
Emerging markets’ bonds faced a remarkable recovery in the second half of the quarter. In fact, on
aggregate they were able to overcompensate for
the losses, i.e. -3.5% in January, as local currency
aggregates indicate. By end of March the respective
return equaled +1.6%.
Harsh U.S. weather and a re-evaluation of gold
helped to support commodity prices. For Q1 the
aggregate DJUBS index was up by 7%. After a
strong start gold retreated again given the prospect
of low inflation, ongoing tapering in the U.S. Yearto-date it appreciated by 6.6% but the pricing
seems to be range bound around USD 1300.
Where do we go from here?
It is comforting that left tail risks, e.g. a country
default in Europe, have been reduced significantly
while visibility has improved as compared to the
more difficult years 2011 and 2012.
2014 continues to be a year of increased divergence, be it with respect to economic growth across
regions and countries, or with respect to asset classes and their components. Hence, successful investments will require careful selection of opportunities.
Undoubtedly, investors must have had second
thoughts about the robustness of the economic
environment and the state of the financial markets.
All of a sudden, doubts about the robustness of the
US economy were back – apart from concerns on
2 | Asset Allocation Outlook – 2nd Quarter 2014
Source: BCA
The following chart is taken from a recent study of
BCA. Chart 2 shows a collection of U.S. economic
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indicators that support the argument for a cyclical
Chart 3: Good News from the Eurozone
banking, in an attempt to introduce “market forces”. As the economy is in transition mode towards
a more consumption led economy, the infrastructural needs to provide higher urban wages will remain colossal. Nevertheless, the government is
eager to achieve a GDP growth rate between 6.5%
and 7.5%.
Regarding emerging markets, there is no homogenous analysis possible. As stated in the previous
letter, countries with negative current account,
such as Turkey, India and Brazil to name a few,
remain in a weak position.
Source: GaveKal
BCA states: “The purchasing managers’ indexes
and leading economic indicator are firm, retail sales
are accelerating, and unemployment claims are
steadily fading…”, and further: “…the Economic
Surprise index is already depressed, which suggests that the market will react more strongly to a
patch of good news than bad”.
Thus, we do expect that tapering continues as
planned and that the yield curve will shift to the
North. Therefore, we will maintain our short duration exposure.
There are also steadily improving news coming
from Europe. Lately, the PMI for the Eurozone hit
54 which is the highest level in over 4 years. Economic growth could be as high as 1.5% in 2014 as
the latest consensus predicts and maybe higher
next year if this development continues. Researchers from Gavekal further point out that as the Eurozone policy has become less austere and even
allows for some tax cuts, consumer confidence is
on the rise although coming from a low level. See
Chart 3 for an illustration of this development.
According to our view, worries about a meltdown of
China’s financial systems are overstated. The size
of its shadow banking system is dwarfed by countries like the U.S and the Eurozone according to
BIS. Apart from China’s currently deep pockets to
pay its way out of a crisis, we need to realize that
most of these credits are collateralized. Nevertheless the present government will let go of poor
trust companies, which are associated with shadow
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Despite tapering there will be no shortage of global
liquidity. Monetary policies will continue to play a
crucial role. It is clear that continuous interventions
have distorted the pricing mechanisms for risky
assets. The Fed’s move towards normalization
made the USD appreciate across many currencies
including the yen but it remains under pressure
versus the EUR and CHF, for instance. However,
the EUR might not be as expensive as one might
think as Chart 4 indicates when compared to its
purchasing power. Thus, a correction might not be
imminent although the Eurozone could benefit from
another extra 1 percentage point of growth if the
EUR would, in fact, depreciate.
Chart 4: The EUR might not be as expensive as
Some might think
Source: GaveKal
The Marcuard Heritage Model Portfolio Positioning
We observe the current phase of sector rotation
and equity profit taking carefully. As pointed out in
the previous pages the assessment regarding the
economic fundamentals and equity valuations have
not changed. Therefore, we continue to keep equity
and credit exposure as key pillars in our asset allo-
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cation. But we will stay alert to instantly react to
relevant changes in the markets.
We remain confident that these asset prices will be
supported. Although the normalization process for
interest rates has somewhat slowed down it will
continue and there is no imminent need to alter our
strategy to favor low duration exposure and our
focus on credit and loans.
Equity Long/Short and Event Driven managers are
still our preferred choice over straight Beta Longonly equity managers as we expect increased volatilities in the months to come. Equity returns will
most likely be significantly more modest as compared to 2013. We maintain our general equity
exposure with a focus on Europe’s improved stock
market environment. However, we cut our remaining exposure in a Japanese Long/Short equity manager in the more aggressive portfolios.
We keep our exposure to fixed-income instruments
mainly in USD and in European credits and corporate loans. Excess spreads have compressed further but yields are still comparatively attractive. In
addition, default rates remain still very low. We
4 | Asset Allocation Outlook – 2nd Quarter 2014
maintain our preference for short-dated portfolio
duration. Equally, we maintain our tactical position
in favour of emerging market debt in hard currency
to profit from its recent weakness.
We decided to take profit of the insurance-linked
securities as 2014 might face increased weather
risks due to “El Nino”. We will assess later in the
year whether we will re-invest.
We cut one macro fund manager as his current
portfolio positioning did no longer deliver the favorable correlation characteristics versus other funds
we were and still are looking for.
No altered view on gold: Our fundamental view
that gold is, per se, a helpful tool to diversify, has
not changed; but market sentiment and the absence of inflation expectations have clearly turned
against this precious metal for the time being.
Hence, we keep gold exposure at a low level as a
hedge against unexpected macro risks and inflation
Likewise, the overall lacklustre outlook for commodities will not lead to a re-investment anytime
soon in this asset class.
Marcuard Heritage
Market Data Table: Strong Equity Markets for BRIC and Emerging Markets
Source: Bloomberg data
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