EDRG: What to do when the global economy has run out of steam

The next European plan is still shrouded in uncertainty. We may be heading for a plan based on the Eureca project designed by the very Roland Berger cabinet which came up with the Treuhandstalt agency dealing with newly reunified Germany. This plan, which has had so far little publicity, suggests setting up a European institution to look after privatising EUR 125bn of Greek assets. That would reduce the country’s debt to GDP ratio to bearable levels, stimulate growth without impacting demand with austerity measures and also assuage worries over contagion.
Looking beyond the Greek issue and any systemic risk that might follow, economic slowdown is likely to come true because of (i) companies taking a wait-and-see attitude amid systemic institutional instability, (ii) a vast coordinated scheme to tighten up fiscal measures and (ii) a possible clamp down on lending that could send Europe’s overvalued property markets into depression territory. If the UK example is anything to go on, austerity coupled with falling property prices entails stagnation or contraction in domestic demand. Should the same trend be observed on the continent, there could be serious consequences for banks which are already struggling.

– US
There are two areas where the US is ahead of Europe: banks have deleveraged and the property market has been through its correction. According to the IMF, US bank leverage is now only 12 compared to 26 in the euro zone. Property prices have fallen to levels in line with household income. In fact, set against low long term interest rates, they have even become attractive. Even so, it is difficult to see this as a source of autonomous growth. High unemployment is destroying the wage dynamic and fiscal tightening is on the agenda even if it is still unclear to what extent. Companies, meanwhile, have the cash and profitability levels to invest but the end of fiscal incentives in 2012 might trigger a fall in corporate investment next year. We feel that a property market rebound would change the picture but we can neither count on this happening nor rule it out. But altogether, the US economy still enjoys a more moderate risk profile than Europe.

– Emerging countries
Generally speaking, emerging countries rebounded during the crisis thanks to strong loan growth and loose monetary policies imported from the US so as to stabilise currencies against the US dollar. The emerging zone has, as a result, inherited a triple challenge of leverage, inflation and property bubbles. Just as in the US from 2000 onwards, part of the credit boom was totally unreasonable. China, for example, saw the development of opaque shadow banking which took advantage of property developers who are now in difficulty. In Brazil, the default rate on prohibitively expensive consumer credit is rising sharply. Over the short term, this all means that emerging country assets are not acting as the safe havens they were meant to be. However, over the medium term, emerging countries still have much brighter economic prospects as their assets are generally trading at a discount. The time will come when these markets will be worth buying again.

INFORMATION
If the worst case occurs – Europe falling into recession and stagnation in the US- the likelihood is that emerging countries will not only find it difficult to come to the rescue of mature economies but may well fall victim themselves to accidents resulting from the global downturn. Economic history shows that a combination of bubbles, inflation and economic slowdown should encourage investors to be very cautious. Japan at the beginning of the 1990s and the subprime crisis are good examples.

MULTIPLE RISKS, PRACTICALLY NO SAFE HAVENS BUT OPPORTUNITIES NEVERTHELESS
The current environment is clearly not very favourable for risk assets. The market decline since the beginning of 2011 has priced this in part. But it has also priced a certain amount of anticipated bad news. This hyper negative consensus provides potentially fertile ground for the sort of technical rebound that alert fund managers can usefully exploit. From a more fundamental point of view, two investment ideas stand out: the US dollar, as a lot of debt is dollar-denominated and reimbursing it will help send the dollar higher, and currency-hedged Australian bonds. Australia is one of the rare AAA-rated countries with attractive yields of 4.2% on its 10-year bonds. Yields should fall in line with the rapid economic slowdown in emerging countries.

UNDER THE CIRCUMSTANCES, WHAT ARE THE BEST INVESTMENT SOLUTIONS?
In uncertain, nervous markets with sudden, snowball effects and fleeting safe havens, diversification and risk control are more than ever essential. The Edmond de Rothschild QUADRIM 4 and Edmond de Rothschild QUADRIM 8 funds are managed in line with volatility constraints (4% and 8% respectively) and use investment tools that are adapted to
the current environment.

– Management of the funds is broken down into three complementary strategies: yield strategies where the fund manager invests above all in discounted stocks, macroeconomic strategies based on identifying major trends and technical strategies which can generate high performance in very volatile markets. For example, quantitative strategies based on forex trend following have performed particularly well during this crisis. Similarly, long euro volatility arbitrage strategies helped cushion market shocks in August.

– The fund manager makes discretionary and opportunistic investments across a very broad universe comprising equities, bonds, currencies, convertible bonds and commodities in both developed and emerging markets. Emerging debt, for example, held up remarkably well over the summer and our stock selection of discounted niche issuers bolstered the fund’s resilience.

– The funds’ liquidity and their reactive, arbitrage strategies help the fund manager to take positions as soon as a technical rebound has been identified. This means that although the funds currently have a defensive bias, the manager is totally free to adapt the portfolios to changing market conditions. As the outcome to the current crisis is still unpredictable, he is currently focusing on reducing risk to the detriment of hedging positions. Diverse investment styles: Edmond de Rothschild QUADRIM 4 is an absolute return fund launched in 2007 which performed well during the 2008 crisis. Edmond de Rothschild QUADRIM 8 benefits from a complementary performance driver based on long or short directional positions.

The data, comments and analyses in this document reflect the opinion of the Edmond de Rothschild Group and its subsidiaries with respect to the markets and their trends, regulation and tax issues, on the basis of its own expertise, economic analyses and information known to it at present. However, they shall not under any circumstances be construed as comprising any sort of undertaking or guarantee whatsoever on the part of the Group or its subsidiaries. In no event shall the Edmond de Rothschild Group assume liability for any decision to invest, to disinvest or to maintain a position on the basis of these comments or analyses. It is the responsibility of each and every investor to obtain the various regulatory prospectuses for each fund or financial product prior to making any investment and to analyze the risk incurred and establish his or her own opinion, independent of the Edmond de Rothschild Group, and where necessary, to take specialist advice regarding such questions, and especially in order to determine the relevance of such investment to his or her own financial situation. Past performance and volatility is no guide to the future: the value of investments may fall and rise and performance is not constant overtime. Main risks: risks associated with emerging markets, discretionary risk management, equity risk, currency risk, risk of capital loss, concentration risk. The full prospectuses of funds certified by the French market authority, the Autorité des Marchés Financiers, are available upon request or from our website (www.edram.fr). The funds mentioned are only intended for distribution to persons resident in France and this bulletin has not to be regarded as an offer to buy or sell or the solicitation of any units of these funds in any jurisdiction other than France. These funds can’t be subscribed by an individual or an entity if the law in his country of origin or any other country concerning the person or entity prohibits it. For instance, these funds can’t be sold in the United States or any of its territories or ownerships. It cannot be marketed to legal entities or individuals in the United States or to citizens of the United States or United Kingdom.
Edmond de Rothschild Group and its subsidiaries therefore recommend that all interested parties ensure that they are legally authorized to subscribe to the products and/or services before any investment is made.