The decision made by the rating agency Moody’s to downgrade the credit ratings of a string of global banks was greeted inevitably when markets opened on the following day by a sell-off helped by weaker US data and Wall Street down 2%. The strange thing about the rating downgrade is that it came too late, says James M M Edwards (pictured), chief investment officer, Eurofin Capital…

Most banks stock prices are down over 70% from their highs, and multiple “zombie banks” were created in Europe, that only survive through the funding from the ECB. They have been put in what could be called a “long term coma”, being of no use to the European economic system, unable to lend except to sovereigns and unable to borrow from anyone save the Central Banks themselves.

Banks are essential for any economic system to work, and unpleasant as this may seem to many populist politicians, we need banks and we need functioning banks. The transmission mechanism for credit, liquidity, savings and growth is the banking system. If you don’t believe this, look at the failure of the Soviet system to allocate capital and resources, to price credit risk and to lend to projects where the risk/reward correlation makes economic sense for the lender. In Europe, we have been “socialising” the banking system by supporting banks that should be allowed to fail. In doing so, we have created a transmission mechanism that now encompasses all banks as doubtful and has established a direct link between the strength of a banking system and the strength of the underlying sovereign credit itself. The key element to a functioning banking system is trust. Banks need to trust other banks in the system. Without this trust, banks will no longer lend to one another and will lend only to the Central Bank, to high quality borrowers such as large corporate or directly to the Government by purchasing sovereign debt.

We are currently in this position in Europe where the interbank lending market is drying up for many banks, as they are no longer “trusted” by their peers. In addition, because of the introduction of Basel III, banks are now having to adapt to a much more penal capital cost system that makes their traditional lending businesses less profitable as they need to allocate higher proportions of costly capital against the risk of loss. In hindsight, Basel III is a great idea coming at the wrong time, more slamming the stable door after the horse has bolted, than preventative anticipation of problems ahead. In fact, Basel III is probably intensifying the bottleneck in the flow of liquidity to the real economy and is also exacerbating the fear and concerns over the real state of the banks as well as most importantly of all, the reaction of sovereign states to a bank or banks that are failing.
The US decision to let Lehman Brothers fail, and the subsequent bailouts in Europe of banks like RBS, Dexia or Bankia in Spain have confused investors and lenders alike.

Which banks will be supported, which ones will be allowed to fail? The difficulty for the Europeans is that their talk of mutual deposit insurance for all banks in the Eurozone is a great idea but involves yet more inter-mingling of sovereign risk with those of the banks and we really need to wean people away from the idea that lending to a private sector bank is the same as lending to the sovereign. Maybe we will begin to see more private sector haircuts being required in order to bail banks out, at least this will allow investors and the banks themselves to differentiate the levels of risk.

I would like to see more effort being made to encourage banks to off-load their bad and non-performing assets. A better use of tax payer funds would be to capitalise a series of bad asset vehicles. If done in conjunction with new private sector capital being raised for the “clean” component of the bank, this would enable banks to begin making new loans. As the US did after the S&L crisis, poor banks that could not raise new capital closed and the state took over the bad assets and began a long but managed unwind of these positions. The benefit of this process is a cleaning up of the sector, limited state intervention and a clear line drawn between sovereign risk and private sector bank risk. The complicated European environment with multiple stakeholders and divergent national interests will probably make this impossible to achieve, and as one member of our Investment Committee commented recently, there is a real danger of Europe “going Japanese”, locked into a prolonged period of low or negative growth, no inflation and over-leveraged under-capitalised banks.

Even though it is hard to imagine how we can exit this situation in one piece, my firm belief in the resilience and capacity of the human spirit to overcome adversity continues to foster an optimistic outlook for the future. Our recent Quarterly Investment Committee also concluded with a constructive bias on the outlook for stocks and for recovery to continue in the US, albeit at growth rates markedly lower than in previous recoveries.
Quarterly Investment Committee Outlook We take most of a day to reflect on the current situation and to position our views for the next quarter. In the current environment, I am often unsure as to how, if at all, our portfolio positioning will change, such is the level of uncertainty and the difference of views that we find in the many commentators that we follow. As always, our guidelines are based on longterm objectives for growth and capital preservation. These are not mutually exclusive and our portfolios tend to have historic volatility more often associated with fixed income markets, although we are unlikely to ever have over about 40% allocated to this asset class.

Historically, we have tended to use Hedge Fund investments as a long-only equity proxy that has a limited downside risk.

Recently, this allocation has penalised our short term performance as the generic Hedge Fund asset allocation has produced lower returns than either equity or bond markets.

We are prepared to bide our time with this selection as we believe that most funds have sufficiently adapted to a more pro-active risk management approach and, in the current trendless and volatile environment, have tended to run with very low levels of risk. Over time, we expect that this allocation will deliver significant capital growth with very limited downside risk, ideal for our longer-term asset allocation objectives.

At the end of March 2012, we had the following allocation: Composite Index: 40% bonds, 50% Equity, 10% Cash.

Overall, we are therefore under-invested in both bonds and equities relative to our long term “benchmark”, and we have made a big 15% bet on the Hedge Fund investments ability to add positive asymmetric returns to our portfolio. After much discussion we have adjusted the portfolio by reducing Cash to zero and by adding this 5% allocation into Equity, taking it to 50%. There was much discussion prior to this decision as we obviously do not know if the Euro farce will continue to play havoc with confidence and therefore with equity valuations globally, or whether this will be confined to Europe. We did however think that valuations were now at levels where we should be at least neutral relative to our long term target weight. As we tend to have a bias towards strong cash producing companies, we believe that owning the earnings stream in Equity is much more compelling than the 10 year Government Bond yield, and in many cases surpasses it.

 


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