23 May 2012

Macro Strategy Update

Buying Opportunity

Headline news has recently been raising the spectre of an impending 'Lehman-type moment' due to the strong possibility of a disorderly Greek exit from the euro zone. However the sharp sell-off in equity markets in recent weeks presents a unique opportunity from a contrarian point of view. Equity markets are pricing in a disorderly Greek exit from the euro as they expect the consequences of such an event to negatively impact global financial markets. Most investors are hence expecting a replay of the weakness in equity markets last year where global stocks lost 24% over five months, starting in May 2011. However, we see signs that point to a more encouraging outlook.

In contrast to the panic selling in equity markets, the fixed income market continues to signal a sense of stability. High yield and emerging market bonds were making new highs right up till May when we saw a wave of panic selling. TED spreads (Figure 1), which is a measure of banks' willingness to lend to each other, remain steady even as equity markets lost 10% in three weeks.

Image courtesy of Stockcharts.com

Figure 1: TED spreads remain steady even as equity markets plunged.

The fact that bond markets are more composed than equity markets is an important signal that investors should not ignore since the global bond market is much larger than the global equity market. This shows that the risk of a banking crisis remains low even as equity investors worry about a messy Greek exit from the Eurozone. It also bears reminding that the pre-occupation of a bond-holder is the return of capital versus that of an equity investor which is the return on his capital.

On this point, we take the minority view that the Greeks will choose to remain in the euro zone for the simple reason that it is a less painful choice. The nightmarish consequences of abandoning the euro and regaining currency independence with the drachma will make the current Greek recession seem mild in comparison. No sane politician would risk this step, which is why even the hard left wing leader, Alexis Tsipras emphasized his intention for Greece to stay in the euro, but with a loosening of the austerity conditions to allow growth.

Another piece of positive news, as compared to 2011, is that oil prices have been falling this year, thus easing cost pressures on businesses and thus promoting economic growth. Hence we think that equity markets may have been over-pessimistic on the odds of a messy Greek exit and thus the sell-off in equity markets presents an opportunity for investors to buy into good assets.

Portfolio Positions

We have decided to take advantage of any weakness in equity markets to buy equities on the cheap. Hence we are recommending a redeployment of up to 10% of the portfolio now currently in short duration bonds to buy Asia-pacific equities. We are preparing the online notifications for your approval. Please talk to your advisers if you have any further questions.

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