By Robert Cookson
The fact that almost every risky asset class in the world has rallied sharply over the past six months is somewhat perplexing for V Anantha Nageswaran, the chief investment officer for the private bank Julius Baer.
He says global investors are ignoring the fundamental weakness of the global economy, especially in developed countries, and he predicts that equities, commodities and other risky assets are due for a fall.
“When we see asset prices going up indiscriminately that should raise a warning signal that once again this is not a fundamentally driven rally,” he says.
Equities in both developed and emerging markets, commodities from oil to copper, and high yield bonds across the world have all experienced double-digit price increases over the past six months – while gold has risen close to an all-time high.
Not that the rally caught Mr Nageswaran unawares. In February, at a time of extreme uncertainty, he recommended that clients bet on extreme outcomes in risky assets by buying deep out-of-the-money put and call options on indices such as the S&P 500. That so-called “barbell” strategy has paid off handsomely as the benchmark US index has soared nearly 60 per cent since its February low.
But the time has come to shift positions, he says, as “the extreme fear and oversold conditions have clearly disappeared”. Now one of his strategies is to buy moderately out-of-the-money put options with a one-year time horizon, betting that a correction will come at some point in the coming year.
In the short term, however, “if investors want to believe that momentum and herd mentality could drive them higher over the next two to three months they could still maintain a call option on the index”, he says. “That’s an acknowledgement of the fact that no matter how convinced you are of the fundamentals, the market can remain irrational longer than you can remain solvent.”
Among the signs of distress in the global economy that he believes investors are ignoring is the fact that bad debts are still accumulating in the financial sector. In the US, for instance, the latest Quarterly Banking Profile from the Federal Deposit Insurance Corporation showed that non-current loans (loans where payments have fallen behind schedule) were rising at a much faster rate than loan loss reserves were being created by banks.
Meanwhile, he says, the true state of banks’ health is being obscured by the relaxation of mark-to-market accounting rules, which have been replaced by “mark-to-mind accounting”.
On a global scale, signs of growth may be less robust than they appear. Take the raft of positive gross domestic product figures from developed countries that have made headlines in recent months, fuelling optimism about a global recovery. Mr Nageswaran argues that commentators have made the mistake of focusing on real GDP figures, which were positive only after being adjusted for deflation, rather than the nominal figures, which showed a truer picture of a fall in aggregate demand.
In Australia, for example, “commentators went gaga over 0.6 per cent real quarter-on-quarter growth in Q2, which basically came about because of a 2.2 per cent deflation rate. So net, the underlying nominal GDP actually contracted for a third quarter in a row, and in fact the contraction has intensified in nominal GDP terms.”
For these reasons, he believes investors should reduce exposure to risky assets such as stocks, commodities and commodity currencies, and raise their exposure to high grade corporate bonds as well as some sovereign bonds.
On the currency front, he says there are opportunities for investors to bet on some Asian currencies appreciating by more than the market expects, especially the Indian rupee and the Chinese renminbi. To do so, he recommends using non-deliverable forwards to lock in two or three-year rates.
For instance, the market is pricing an almost 8 per cent appreciation of the US dollar against the Indian rupee over the next three years. “That’s reflecting the interest rate differentials between the two. But if one believes that Indian growth rates will remain at 6 or 7 per cent or even go higher and investors will continue to seek out Indian investments, then the rupee might appreciate.”
As a longer term view, he recommends that investors drip money into equity markets such as India, Indonesia and Vietnam “because they have a huge component of domestic demand, they are big in size and they can support growth of their own dynamic”.