Lyxor Asset Management has approximately $100billion under management and $30billion in alternative investments. Below is their lengthy thesis explaining macro views and investments for 2012
Business Cycle: Our central scenario remains that of a structural debt deflationary backdrop. Deleveraging is ongoing, and growth rates should remain below potential. Nevertheless, reflationary forces have recently gained ground, and progress has been made on the path to normalization. The improvement is striking in the US, where credit is again expanding. With elections looming in November, we expect fiscal tightening to be delayed until 2013. Economic momentum should thus remain supportive in 2012. Housing could offer a welcome positive surprise. In Europe, we do not expect any straightforward solution to the sovereign debt crisis. Many hurdles remain, and downbeat activity is one of them. Nevertheless, now that the ECB is de facto monetizing debt behind the scene, systemic risk has declined. More globally, we expect a synchronized slowdown in inflation. In developed countries, this will mean higher real rates. In developing ones, it will allow dovish monetary policies.
Asset Classes: Markets are likely to remain caught between the structural debt-deflationary backdrop in developed countries, central banks’ massive reflationary efforts and the recessionary impact of fiscal consolidation. We believe reflation should gradually gain ground. The major downside risk lies in the Eurozone where banks’ deleveraging could worsen the ongoing recession. However, the ECB’s backdoor quantitative easing has capped systemic risk,
triggering a turnaround in market sentiment. The sharp relief rally has corrected extreme undervaluation but risk premiums remain attractive. We are shifting to a more constructive view and are selectively adding exposure. The road towards normalization should be detrimental to overvalued safe havens such as high grade sovereign bonds. We think U.S. corporate health is
not yet reflected in credit markets that offer an attractive risk reward profile. We favor U.S. equity amid improving fundamentals. Yet, we are less cautious on Europe as the deep valuation gap with the U.S. should start to close. In particular, a better policy mix should support UK equities. Positive long term growth prospects, further monetary easing and undemanding valuation keep
us positive on Emerging markets.
Alternative Strategies: We continue to see significant opportunities for managers in the L/S Credit space and for managers on the lookout for valuation mispricings and hard catalyst opportunities. Correlation and volatility are at lower levels than they were at the highs of 2011, which is currently benefitting hedge fund managers. Thoughtful managers recognize this good tone to the markets might not last forever – markets rarely move in a straight line – and manage their portfolios accordingly. We downgrade L/S Equity Quant managers to a Slight Underweight ranking.
REFLATION SLOWLY GAINS GROUND
Our central scenario remains that of a structural debt deflationary backdrop. Deleveraging is ongoing, and growth rates should remain below potential. Nevertheless, reflationary forces have recently gained ground, and progress has been made on the path to normalization. The improvement is striking in the US, where credit is again expanding. With elections looming in November, we expect fiscal tightening to be delayed until 2013. Economic momentum should thus remain supportive in 2012. Housing could offer a welcome positive surprise. In Europe, we do not expect any straightforward solution to the sovereign debt crisis. Many hurdles remain, and downbeat activity is one of them. Nevertheless, now that the ECB is de facto monetizing debt behind the scene, systemic risk has declined. More globally, we expect a synchronized slowdown in inflation. In developed countries, this will mean higher real rates. In developing ones, it will allow dovish monetary policies.
- Politics & policy dominate economics
In 2011, political uncertainty has been a major hurdle on the path to economic recovery. The spiraling European debt crisis showed how detrimental the combined lack of governance and proactive political action could be. In the
United States, the fiscal stalemate was at the root of the loss of the AAA credit rating.
In 2012, again, politics and policy will remain key to the economic outlook. 2012 will see a heavy agenda of elections both in the United States, with the presidential election coming up in November, and in Europe, with elections looming in several countries (including France, and Greece). In China, the 18th National Congress of the Communist Party will undergo a leadership change this autumn.
In our view, reflationary forces have recently been gaining some ground. However, the battle against structural debt deflationary forces has not yet been won. In such a context, policy and politics will set the trend. In the end, it is the commitment to reflation which will make the difference.
In Europe, we do not expect any straightforward solution to the sovereign debt crisis. Policy makers retain all their market disappointment potential and austerity is triggering a vicious and negative economic cycle. At the current stage, most deficit targets are out of reach. Yet, the ECB’s LTROs have offered significant breathing space to the banking system and are nothing else that quantitative policy in disguise. As for politicians, there is increasing awareness that restoring growth is paramount to restoring fiscal soundness. Even though we are far from positive on Europe’s economic growth perspective, we think systemic risk – which was reflected in last year’s extreme risk premiums in European equity
markets – has declined and that the worst has probably been averted. We remain of the view that the scenario of a Euro zone breakup has a very low probability. We think that Europe will (painfully) have to learn to live with fiscal austerity, depressed consumption and high interest rates. The central scenario is thus one of a painful and chronic muddle through. Yet, for investors, the absence of a full euro meltdown is positive in itself. A structurally downbeat macro environment can thus be consistent with some normalization in risk premiums (see our asset class section for our views on European equities).
In the United States, beyond the positive impact of short term factors, reflation is slowly gaining ground. The Fed remains committed to supporting the economy and will not hesitate to move if growth disappoints. Fiscal discipline will have to kick in at some point, but elections have never been won with recessions and we believe the fiscal retrenchment will come rather later than sooner. The US housing sector remains a wildcard, and, after nearly six years of contraction, a recovery would be a welcome upside surprise, putting the US on the path to a more sustainable recovery.
Lastly, we think Emerging markets will not remain immune to the European growth slowdown. However, we continue to expect a soft landing and no hard crash. Inflation across the globe will recouple on the downside in 2012, and this trend change should be particularly visible in developing countries. In such a context, policy easing should gain momentum.
- Europe. A recession followed by chronic weakness
Europe remains faced with many hurdles. Most of them will probably not be overcome in 2012. The sharp decline in industrial output and the plunge in leading indicators at the end of 2011 both underscored that the region probably fell back into recession during the fourth quarter of 2011.
Going forward, recent data has seen main leading indices, such as the European Commission’s business cycle and economic sentiment indicators bottom out, buoyed by a stronger momentum in the United States. In Germany, both the IFO and the ZEW have increased. As shown by the uptick in the Citigroup economic surprise index, the Euro zone has recently surprised to the upside. In our view, these “positive surprises” are linked, not so much to a strong underlying economic momentum, but to very downbeat forecasters!
Fiscal austerity, the high uncertainty generated by the sovereign debt crisis, a steep interest rate curve south of sovereign debt crisis, a steep interest rate curve south of France and the credit crunch that will go hand in hand with the balance sheet adjustments in the banking sector, should all significantly dampen growth. Chronic weakness lies ahead for the Euro zone.
- No straightforward solution to the Euro Crisis, but receding systemic risk
Ahead of last year’s October Eurogroup meeting, hopes were high for a decisive solution combining fiscal solidarity, credible medium and long term fiscal solutions, and official ECB monetization of sovereign debt. The Euro package
fell short of these hopes. Chancellor Merkel and the ECB made it clear that there would be no “bazooka“ solution for the Euro zone. As disappointing as this was, we had to acknowledge that there would be no straightforward “Fedlike” solution to the European crisis.
Since then, we have nevertheless seen policy moves which, in our view, have contributed to an improvement in systemic risk.
First, funding strains in the euro area banking sector have, to a large extent, been addressed. The ECB’s three year LTRO which was massively subscribed by European banks (around EUR 480 bn for the January allotment) is nothing else but quantitative easing in disguise. This unconventional ECB move simultaneously targets sovereign debt markets and the banking sector’s profitability. The hope is that banks will use the funds to purchase sovereign debt and thus put an end to the
snowball effect of rising sovereign yields. At the same time, the LTRO offers banks an opportunity to prop up revenues. In our view, financing 3Y Italian debt yielding around 4.5% with a 1% funding seems an attractive, and, at the current stage, low risk opportunity. As for the US dollar funding squeeze, it has been alleviated by a coordinated world central bank move, which helped the
Euro-USD basis swap spread recover from -160bps end November to a current -68bps.