International Outlook - When will the trendless volatility end?

01 January 2012 - Tony Gibson

As 2011 drew to a close it certainly felt as if the trend for the year was a pretty dire bear market; such was the ongoing arrival of negative news – especially out of Europe. In reality, the outcome for 2011 – from an equity index point of view – was fairly benign, with equity markets in aggregate falling by a relatively small amount for the year. Unfortunately, the most noticeable upward trend was that of volatility. Even though US stocks were flat for the last three months of 2011, the average daily move in the S&P 500 Index was 1.6%. A level normally only seen during crises. In the history of the S&P 500, there has never been a day when all 500 names were either positive or negative. However, on just eleven days in its 55-year history have 490+ stocks been either positive or negative. Six of those eleven days occurred since July 2011. This trendless volatility was of course a consequence of the fears in relation to sovereign debts in Europe, and the resultant risks to the global financial system. It would be easy to dismiss the extreme volatility experienced during 2011 as irrational, but the current liquidity concerns are very real. The recent statements from the governor of the Bank of England indicating that the situation is ‘extraordinarily dangerous’ should not be dismissed as unnecessary hyperbole. Recent events in Europe have been extraordinary; not just due to the severity of the situation, but also due to the sometimes comical lack of decisiveness from European politicians.

Most commentators – and there is no shortage of them at present – believed that the rescue package agreed in late October looked like a credible solution, which would remove some of the tail risk of a eurozone collapse. However, this was quickly undone by the news that the then Greek Prime Minister planned to call a surprise referendum on whether or not to accept the newly agreed austerity package; thus calling into question the eurozone/IMF rescue package agreed upon just days before. The markets went into shock and risk aversion returned immediately. The Greek government quickly fell and was soon followed by Silvio Berlusconi in Italy; both countries subsequently appointing technocratic replacement governments with the mandate to cut spending and restore health to public finances. This was in turn followed by a change of government in Spain; with the winning party being elected on an unambiguous ticket of severe austerity measures. The gravity of the situation – as illustrated by a sharp increase in the Italian and Spanish bond rates – has elicited continued
dramatic responses from both the leading European politicians and global central banks. In late November a co-ordinated action was taken by central banks to reduce near term bank liquidity concerns, while in early December important steps on the road to fiscal union were announced.

There seem to be three overlapping schools of thought regarding the best remedy for the eurozone problems. There are those who think that the European Central Bank (ECB) should be the ultimate guarantor of eurozone debt; using the printing press to achieve this if necessary. Essentially, this is quantitative easing as recently practiced by the US Federal Reserve Bank. Secondly, there are those who think that the profligate southern European countries should get a grip on their irresponsible spending. They – Germany being the most significant – argue that no progress can be made on joint debt guarantees by the ECB until this requirement is first fulfilled. Thirdly, there are those who think that the euro is bound for a bust-up. Their belief is that the euro was an ill-conceived project from the outset, and that its demise is both inevitable and

The Foreign Minister of Poland put the position of the first school of thought in a powerful article in the Financial Times, stating ‘We ask Berlin to admit that it is the biggest beneficiary of current arrangements and that it therefore has the biggest obligation to make them sustainable. Germany is not an innocent victim of others’ profligacy. The biggest threat to the security and prosperity of Poland is not terrorism, and is certainly not German tanks, not even Russian missiles. It is the collapse of the eurozone.’ He added ‘I fear German power less than I fear its inactivity.’ This view seems to be in the ascendancy, with the likelihood that Germany, abetted by France, will ultimately allow large scale ECB easing, possibly IMF intervention, in conjunction with austerity packages. 

Coronation’s view is that thus far all rescue attempts have merely bought more time by dispensing medicine  to a sick patient. The inescapable issue is that the rate of unemployment in Spain is 23%, and nearly 50% among 18 to 25 year olds, while in Germany it is 6%. The eurozone’s fundamental problem is the 30% gap in competitiveness between the north and south. In the medium term, the only positive outcome is therefore for European policymakers to force the necessary sovereign debt losses to be taken, and for the troubled banking systems to be recapitalised. Only this action, albeit dramatic and painful, will allow the investing world to take Europe off their newspaper headlines.

In the meantime, the good news for investors is that, although there is great disagreement about which is the right scenario, unanimity that the position in Europe is bleak has resulted in this gloom already being reflected in low valuations.

While the investment world remains fixated on the problems in Europe, a more positive trend appears to be emerging on the other side of the Atlantic. The indications are that the US economy is getting back on track. Job prospects are improving, home prices are stabilising, and the US consumers are opening their wallets a bit more freely. More importantly, for the first time during the economic recovery, banks are lending more. After a tentative recovery earlier in 2011, bank credit rose at a 3.9% annual rate in the third quarter and has been accelerating in the fourth quarter. As we know, banks’ greater willingness to lend – particularly to job creating small business – is crucial for any improvement in real GDP growth in 2012. Although well short of the high growth levels experienced five years ago, consensus forecasts are for real US GDP growth to accelerate (from 1.7% in 2011) to 2% and 2.6% in 2012 and 2013 respectively.

While fundamentals in the US look solid, the question is whether continued strain in Europe will hamper US corporate profits. Broker forecasts for 2012 are suggesting earnings growth by US companies – based on US fundamentals alone – of around 10%. However, due to anticipated weakness in Europe, these forecasts have been pared back to low single digit increases. It is our opinion that the risks to these forecasts lie to the upside. One reason for this could be if the most dire forecasts for Europe do not materialise. However, an upward revision is more likely to occur due to a positive surprise from the level of economic activity in the US, as domestic growth continues to recover. If so, earnings would come in significantly stronger than expected. In addition, if the outlook for earnings improves or there is more certainty regarding economic outcomes, we would expect valuations to receive a significant lift as improved prospects for 2013 are factored in.

Taking a line through the Coronation World Equity Fund of Funds’ performance in 2011, it is clear that this has not been an easy environment for our managers to add alpha. Collectively in fact they have generated negative alpha. We believe that, in time, the present volatility will settle back to historical levels, and investors will intimately assess the value of equities based upon fundamentals – not momentum or the perceived crisis of the hour. We remain optimistic regarding the potential returns from the equities in our portfolios and believe that the value of these companies will eventually be reflected in their stock prices, and accordingly returns will be more consistent with our historical performance.

While we are of the opinion that the current environment presents buying opportunities for the patient investor, we remind ourselves that careful stock selection is needed to identify attractive investment opportunities. Investors cannot ignore the fact that profit margins for companies in the S&P 500 are at or near their historical peaks. Similarly, the business models of many businesses are now under threat – either from technological innovation or new international competition. As a result, the profit margins currently achieved by many leading companies are unsustainable, leading us to conclude that those companies that do have robust business models will materially outperform the market average.

It would seem that now, more than ever, extraneous factors are driving short-term market performance. This is often referred to as ‘noise’ in financial jargon and can include comments from a politician in a European nation, or a rumour regarding the exposure levels of a global financial institution. Fundamental investors attempt to avoid such ‘noise’ and focus on individual companies within the context of the global economy. Of course, ignoring such short-term manias can result in underperformance over short periods of time. However, attempting to react to and trade based on such events will almost assure long-term underperformance simply due to the trading costs involved. Equity markets are currently rife with shares that are broadly misunderstood by the investment community, and it would appear that the widespread adoption of ETFs is
only acting to increase these pricing anomalies. As investors have slowly returned to equity markets after the markets recovered from the crisis of 2008, they have increasingly been utilising ETFs as the preferred vehicle to gain market exposure. The large majority of ETFs are passively managed indexation strategies that attempt to capture broad market returns. Such indices often exclude the best performing shares because of size and/or liquidity constraints. Additionally, there are increasingly focused ETFs that invest in a specific sector or country. For example, an investor can own an ETF of a certain index excluding financials if one were disinclined to own financial companies.

We prefer to invest via active managers, who base their investment decisions on sound, long-term, and
proven investment fundamental analysis.

TONY GIBSON is a founder member of Coronation and a former CIO. He was responsible for establishing Coronation’s international business in the mid-1990s, and has managed the Coronation Global Equity Alternative Strategy Fund since launch in 1996.


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Note to the editor:

Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 29% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Mbabane, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange.