professional investors - July/August
ForFor professional investors - JANUARY 2011
CONTENTS To the rescue
MARKETS & EXPERTISE
Economic Outlook 2 Cyclical momentum in the US economy remains fragile: it was virtually impossible to
US economy: not so bad find a single positive element in the labour market report released on 8 July. This means
that investors will approach the early August release with even more trepidation than
Risk & Asset allocation 3 before. Another truly bad number and there will be a further surge in “double dip”
Allocation in the current market turmoil articles on media websites.
Money Market 4
How will new fund categories affect As one would expect, Fed chairman Ben Bernanke is more than aware that the US
European money market funds? economy has now arrived at a crossroads and he took the opportunity of his recent
testimony to Congress to make it clear that he is ready to come to the rescue yet again.
Emerging Markets 6 Despite ultra low rates, QE1 and QE2, he still sees ways to use monetary policy to try
Will China experience a soft or hard to push the economy into a higher gear. This decisiveness is hard to find on the fiscal
policy front where there seem to be endless discussions on increasing the debt ceiling.
Global Fixed Income 8 Fortunately, markets are rather complacent about it. It’s like the patient traveller:
Globalisation’s impact on developed traffic jams don’t matter if there is confidence one will arrive at the destination.
market inflation In contrast, the road towards stability in the eurozone looks increasingly long and
winding and travellers are becoming increasingly impatient. Spreads have widened in
Developed Equities 9 countries which thus far had remained insulated from contagion - Italy in particular
Japan: after the pain, the healing
has been making headlines. Fortunately, the Italian government has reacted swiftly
and measures have been taken to reduce the budget deficit.
Nevertheless, investors are very much aware that for the eurozone as a whole
Expert’s View 10 “something” needs to be done to bring interest rates back to more sustainable levels.
Demystifying risk-based strategies The complexity of the task is huge but the rewards warrant the effort.
for equity portfolios
Interview 12 As always, do not hesitate to contact your Client Relashionship Manager for further
THEAM: flexibility, innovation and discussion.
Written 15 July 2011
William De Vijlder
CIO Strategy and Partners
2 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
Strategist - BNPP AM
US economy: not so bad
It may be because the holiday season is getting near, but the Forget the data for a while
plethora of economic indicators published in the United States The former Fed chairman, Alan Greenspan, reputedly consulted
each month is becoming oppressive. The US statistical system numerous economic indicators while taking his bath. Although
includes an impressive number of varied surveys, in addition to he left the top post at the Fed in early 2006 with plaudits, in the
the data actually measured (e.g. sales and output). Since these autumn of 2008 he had a less comfortable time explaining to
surveys mostly concern the very cyclical manufacturing sector Congress why he had not taken the necessary measures to prevent
(which now only accounts for about 15% of GDP), the resulting view the sub-prime crisis. This misfortune leads us to take an objective
of the economy becomes even more blurred, arousing erratic mood view to draw up our scenario for the US economy in the second
swings in investors and analysts, neither of whom have any need, half. The first half was marked by a slowdown in business activity
to be encouraged down this path. due to two factors: firstly the difficulties of the automotive sector
− and to a lesser extent the technology sector − related to breaks
Economic data overload in production in Japan following the earthquake; and secondly
In June, the various surveys conducted by the regional Federal spiralling oil prices until the end of April. The first factor is fading
Reserves (Feds) on industry sources - often purchasing managers - with improved economic activity in Japan, the second factor
blew cold and then hot. This aroused fears, in light of the results in weighed on household purchasing power via petrol prices. Between
New York and the Philadelphia region, of a collapse in the national the end of December 2010 and the end of May 2011, spending
ISM , whereas surveys carried out around Chicago and Richmond, allocated to the “petrol and other energy products” item increased
for example, moderated these fears. The verdict fell on 1 July and, by USD 60 billion on an annual basis, or the equivalent of 0.5% of
contrary to all expectations, the ISM1 Index rose from 53.5 to 55.3, household income, i.e. an amount comparable to the reduction in
showing that industrial activity was regaining some vigour. employee contributions in December 2010 as part of the stimulus
plan. The slight decline in prices seen since May should therefore
Too much attention paid to the data rapidly restore purchasing power to households. Now that the two
It is not the quality of these surveys that is at fault but the fact disrupting factors have left the scene, the US cycle should resume
that economists endeavour to “predict” the results of a survey and its normal course. The “realignment” of productive investment
because these indices were not designed to be scrutinised month should continue for two years after the end of the recession and
after month but to provide data to feed into the econometric employment should continue to improve very gradually. Together
models of the regional Feds. It is not insignificant that the FOMC2 with the real estate market, employment remains the weak link in
uses the Beige Book, a collection of qualitative data for each an economic growth which is disappointing in absolute terms, but
region, to support its decisions rather than the “figures” which which should accelerate in the second half. Until then, forget the
attract more attention from investors. In this regard, one of the data and have a great summer.
economic indicators that generally sets the market tone for the
month , namely the creation of jobs, is now known by some as
the “employment lottery”. For various reasons related to their
collection, the data are frequently revised, often quite significantly,
but will be commented on down to the slightest detail on the first 1 ISM Manufacturing Index, published by the Institute for Supply Management
Friday of each month4 at 8.30 am precisely, New York time. For 2 FOMC: Federal Open Market Committee
3 Note that the fashion regarding indicators reputed to influence the markets (“market movers“)
some time now, there has been heavy criticism not only of the fluctuates. The oldest market economists probably still remember how the US trade balance
extreme variability of the data, but also its objectiveness. The jobs report was able to influence the USD on publication, whereas it is now received with more or
figures in particular are being attacked at present with Bureau of less widespread indifference.
4 In July, the employment report was published on the eighth of the month for calendar reasons.
Labor Statistics (BLS) statisticians being suspected of “inventing”
5 The scale of long-term unemployment explains why the subject has become so sensitive, and
jobs that do not exist when openly making the customary essential the 6.2 million people unemployed for more than six months may legitimately wonder where is
corrections to the raw data5. the slight improvement noted in the BLS figures.
Consensus forecasts: Growth & Inflation
July 2011 GDP YoY % Inflation YoY %
M= Mean; H= High; L=Low 2010 2011 2012 2010 2011 2012
Developed Economies M H L -1M M H L -1M M H L -1M M H L -1M
USA 2.9 2.5 2.9 2.2 [2.7] 3.1 4.4 2.4 [3.2] 1.6 3.0 3.4 2.7 [3.0] 2.1 3.3 1.4 [2.1]
Canada 3.1 2.8 3.2 2.4 [2.9] 2.6 3.1 1.5 [2.7] 1.8 2.8 3.4 2.2 [2.7] 2.1 2.6 1.6 [2.1]
Eurozone 1.7 2.0 2.3 1.6 [1.7] 1.7 2.2 1.2 [1.7] 1.6 2.6 2.9 2.4 [2.5] 1.9 2.2 1.4 [1.9]
UK 1.3 1.6 1.9 1.2 [1.6] 2.1 3.1 1.5 [2.2] 3.3 4.3 4.6 3.8 [4.1] 2.5 3.6 1.7 [2.3]
Switzerland 2.6 2.3 3.1 1.8 [2.4] 2.1 2.4 1.6 [2.0] 0.7 0.9 1.5 0.4 [1.0] 1.2 1.8 0.5 [1.4]
Japan 3.9 -0.7 0.3 -1.5 [0.0] 3.2 5.0 2.2 [2.8] -0.7 0.3 1.0 0.0 [0.4] 0.2 0.7 -0.6 [0.2]
Australia 2.7 2.0 2.8 1.0 [2.7] 4.0 4.8 2.9 [3.8] 2.8 3.4 3.7 3.0 [3.3] 2.8 3.4 1.9 [2.9]
Source: Consensus Forecasts as of 09/05/2011
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3 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
RISK & ASSET ALLOCATION
Head of Strategy - BNPP AM
Allocation in the current market turmoil
Markets are being buffeted both by fears regarding What allocation do you recommend at present, then?
global growth and by the eurozone sovereign debt We did not reduce our allocation risk in early July; on the contrary,
crisis. How should we react? we even slightly increased it to developed market equities. This
After a short upturn in early July following a favourable vote is because we were in a wait-and-see position after “trimming
by the Greek parliament and better US economic figures, there our sails” in May to ride out a period of less favourable economic
has been a very significant deterioration in investor sentiment, data. We believe that this phase is nearing an end and that the
mainly due to the eurozone situation. The worries have spread dynamics of the US economy should provide reassurance in the
to major economies such as Spain and Italy – not because these coming months, given that companies are still in very good health.
countries are not meeting their deficit reduction targets, but There remains the sovereign crisis: it is extremely difficult to give
because there is a risk that they might fail. a time frame for the end of the crisis and to measure the economic
and financial implications of what is happening currently. However,
This attitude undoubtedly encompasses several concerns: the counting on a response from the eurozone to this crisis and bearing
unsettling situation of the smallest peripheral countries, the in mind that the rest of the market picture is far more favourable
unpredictable impact of the rating agencies as crisis catalysts (strong global growth, rising corporate profits, inflation which
and the apparent inability of the Europeans to agree on the should cool somewhat in the second half, etc.), we remain “long
decisions to be taken or to evaluate the scale of the challenge on risk”, mainly via equities, high yield bonds, emerging debt and
they face. industrial commodities (oil and metals).
It is at such times that one must keep calm and ask oneself What position have you adopted regarding government
where the solvency problems lie, what the possible tools are bonds?
to halt the crisis, and what the next steps could be. Regarding We remain close to neutral. The main factor determining long
Spain and Italy, we think the current problem is more one of yields in Europe and the United States in the near future will
liquidity or risk aversion than of solvency. probably be risk aversion, rather than economic fundamentals
alone. In the short term, even though their valuations appear
Moreover, the Europeans can fight back, by enlarging the strained, US Treasuries and German Bunds should benefit further
European Financial Stability Fund (EFSF), or by ensuring that from any additional tension because of their safe haven status.
the European Central Bank (ECB) takes on a role as lender of Subsequently, however, should the sovereign debt crisis be
last resort and “monetises” public debt. So panic will not help resolved and growth prove to be resilient, long yields could rise
matters. sharply in both these countries.
MULTI-ASSET CLASS EQUITIES DEVELOPED COUNTRIES EQUITIES EMERGING COUNTRIES
CURRENT PREVIOUS CURRENT PREVIOUS CURRENT PREVIOUS
EQUITIES US + + Brazil - -
Developed Equities + = Canada - - China + +
Emerging Equities + + Euroland = - India = -
FIXED INCOME Japan + + South-Korea + +
Government Bonds = = UK + + Taiwan = =
Corporate Bonds = = Switzerland - - Russia + +
High Yield + + Australia - - South Africa = =
Emerging Debt (ext.) = = Turkey - -
Emerging Debt (local) + + BONDS COUNTRIES SOVEREIGN
COMMODITIES CURRENT PREVIOUS
Brent Oil + = US - +
Base Metals + + Euroland = -
Gold - = Japan = =
Agricultural = = UK + +
CASH - - Switzerland = =
Notes: The indications in the tables reflect views not weights, whereby the “+”, “-” and “=” signs respectively represent positive, negative and neutral views. Two different types of views are expressed
in the tables. Those in the Multi-Asset Class Module are absolute returns views, or more precisely views on excess returns versus cash. Those in the equities and bond modules are relative return
views. Here we assess relative excess returns amongst different countries. These views can of course be translated into portfolio weights. Their size will heavily depend on portfolio constraints and
the specific risk budgets.
Source: BNPP AM - July 2011
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Investment Specialist – Money market
How will new fund categories affect
European money market funds?
The European Securities and Markets Authority (ESMA)1, the The table below summarises the differences between the two
institution that oversees regulatory reform in Europe’s financial new types of money market funds.
markets, published a common definition of European money
market funds in May 2010. This reform, which Europe’s financial What does this mean for euro-denominated money
community had been awaiting, was adopted by the main leading market funds?
financial authorities (France, Luxembourg and Ireland) in the The turmoil in the financial markets over the past four years has
first half of 2011. The new rules aim to tighten requirements obliged money managers to narrow their investment universe,
on money market funds and enhance investor information and for example by shunning long-term securitisation instruments.
protection. The new European regulations that came into effect on 1 July
2011 will encourage this trend, since money market funds will
In detail: the new funds’ classification and the main no longer be able to invest in A-3/P-3/F-3 rated securities. Debt
rules that apply issuers with this short-term credit rating should be impacted by
EMSA guidelines set out a two-tiered approach with two sub- this decision.
categories: Over the past few years, rising risk aversion and the announcement
• The ‘short-term money market’ funds of regulatory changes in European money market funds have
• The ‘money market’ funds encouraged the emergence of new financial instruments, such
as putable bonds2 and certificates of deposit. Although these
These two new categories became compulsory on 1 July 2011. instruments are mainly used by money market fund managers
Money market funds created after this date must comply with to increase diversification, they also meet the stricter fund
the new rules, while those in existence prior to 1 July 2011 have regulation criteria regarding maximum maturity, interest rate
six months to achieve compliance. risk exposure and of course liquidity. In contrast, money market
fund managers have been gradually reducing or even eliminating
Short-term money market funds are subject to stricter exposure to floating rate notes, a market which they traditionally
requirements than other money market funds in terms of: added liquidity to.
• The maximum residual maturity of portfolio securities Beyond these factors, we believe the impact of the new money
• Their exposure to interest rate risk market fund classification will be relatively limited, since most
• The credit ratings of portfolio securities of this industry’s participants have quickly adapted to the new
• The funds’ exposure to credit risk. rules after their official announcement in May 2010. Investment
management companies have also been careful to offer a range
A money market fund’s exposure to interest rate risk is measured by of financial products that are compatible and consistent with the
its weighted average maturity (or WAM). This is the fund’s average new regulations. For example, some money market funds with
modified duration expressed in number of days. The portfolio’s higher levels of credit risk exposure (i.e. in the ‘money market’
exposure to credit risk is measured by working out the weighted fund category) have added more defensive ‘short-term money
average life (or WAL) of the fund. Calculated by taking into account market’ funds to their offering. Among the latter category it
the maturity dates, it is also expressed in number of days. should be noted that AAA-rated funds have been very successful.
CRITERIA SHORT-TERM MONEY MARKET FUND MONEY MARKET FUND
Investment objective To preserve principal and provide returns in line with money market rates.
Permitted instruments Money market instruments and deposits with financial institutions. Other financial instruments are also permitted provided that they
comply with the investment objective and are consistent with all aspects of the risk profile.
Forbidden exposure The funds may have no exposure to equity markets or commodities
Currencies Currency instruments may only be used for hedging purposes
Maximum residual maturity 397 days Two years, provided the interest rate is reset within no more than 397 days
Portfolio’s weighted average maturity 60 days 6 months
Portfolio’s weighted average life (WAL) 120 days 12 months
Net Asset Value (NAV) Calculated daily, stable and/or fluctuating NAV Calculated daily, fluctuating NAV only
Permitted funds Can only invest in ”short-term money Can only invest in ”short-term money market” funds and /or ”money
market” funds market” funds
Instrument ratings The fund must invest in financial instruments of The fund must invest in financial instruments of ”high quality” (i.e. at
”high quality” (i.e. at least A-2/P-2/F-2, or, if not least A-2/P-2/F-2, or rated internally). Sovereign debt must be at least
rated, internal rating) investment grade.
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These AAA money market funds meet even stricter investment The EONIA is likely to remain volatile over the coming months as
criteria than the short-term money market funds, particularly in it varies with the ebb and tide of excess liquidity in the interbank
terms of the minimum credit rating requirement: A-1/P-1/F-1. market. This excess liquidity will depend on such factors as
Rising inflationary pressures in the eurozone since December how quickly banks will be meeting their reserve requirements
20103 have led the European Central Bank (ECB) to raise its and how thirsty for liquidity they will be during the ECB’s
refi rate by 25 basis points twice so far in 2011: once in early weekly refinancing operations. However, the recent flattening
April and again on 7 July, thus bringing the refi rate to 1.50%. of the EONIA curve could over the short term gradually whet
In response to these successive rate rises and the still high the appetites of money market funds for fixed rate investments,
volatility of overnight interest rates (as measured by the EONIA mainly on short maturities (i.e. 3-month) initially. Thus, after
index)4, money market portfolio managers have been maintaining heavily favouring variable rate securities indexed to EONIA, we
cautious interest rate exposure. Even though the ECB’s president expect money market portfolio managers to slightly increase
Jean-Claude Trichet signalled in early July a possible pause in their exposure to interest rate risk (or “WAM”). However, we do
interest rate increases in the eurozone, inflation will continue not think that the additional leeway for interest rate exposure
to be closely watched. Whereas on 7 July the market was still that the ‘money market’ category funds have will give them a
anticipating overnight interest rates to increase significantly over substantial advantage over ‘short-term money market’ funds in
the rest of 2011, such expectations rapidly dissolved especially the near term.
after the lowering of credit ratings on peripheral countries. Thus,
even as the prospect of the ECB raising its policy rate a third
time in 2011 began to fade, the 1-month EONIA futures curve
flattened sharply from 7 to 13 July, as shown in the chart below.
Contrats futures Eonia 1 mois
courbe au 07/07/2011
courbe au 13/07/2011
1 The European Securities and Markets Authority superseded the Committee of European
Securities Regulators (CESR) on 1 January 2011.
2 These give the debt-holder the option (generally each quarter) of either keeping the security
and earning an increasingly high rate of return or cashing it in for par value.
Jul 11 Aug 11 Sept 11 Oct 11 Nov 11 Dec 11 Jan 12 feb 12 Mar 12 Apr 12 May 12 June 12 3 Eurozone inflation was estimated at an annualised 2.7% in June 2011; in line with the
confirmed rate of 2.7% in May 2011. Rising energy and commodity prices account for the bulk
of this inflation.
On 13 July 2011, the market was expecting the EONIA rate 4 Since the ECB’s termination of its six and twelve-month refinancing operations in 2010 and
to average only 1.41% in December 2011, vs. 1.585% a the gradual evaporation of excess liquidity in the interbank market, the rebuilding of minimum
week earlier. bank reserves and bank participation in the ECB’s weekly refinancing operations have had a
regular impact on interbank liquidity and EONIA fixings.
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Investment Specialist – Emerging Markets
Will China experience a soft or hard landing?
Despite continued concerns over China’s economic outlook, its economy is still rampant, with GDP of some 9%
projected for 2011. Nevertheless, the country is going through a complex transition from export-led growth
to more sustainable, domestic consumption-led growth. The question on most investors’ lips is whether the
Chinese government will succeed in engineering a soft landing for the economy and keeping growth on track.
Three trends worrying the market In fact, we believe the Chinese authorities intend to engineer
Currently, the market is focusing on three interrelated factors: a ‘soft landing’ for the economy, which we would define as
inflation, which has generally been higher and more persistent slowing the GDP growth to a rate of around 8% over the medium
in emerging markets than was expected at the beginning of term, reducing energy-intensive and polluting industries and
2011; the level of economic activity; and recent concerns over moving up the value chain from low-value exports to high-value
corporate governance and local government funding vehicles technology and domestic consumption. Whether the government
(China’s ‘sub-prime’). Our view is that negative factors, such as can achieve this soft landing, outlined in its 12th five-year plan,
food price inflation, are partly offset by positive points. The last is unclear, but China has a good track record of managing such
PMI release was above the consensus, and property construction shifts. Naturally, investors are interpreting this environment
remains strong despite administrative counter-measures. The as risky, which has been contributing to the current volatility.
trade surplus has also surprised on the upside, with more robust However, if China were to fail in this steady transformation over
export growth to the US and Asia. Imports have been lower as the next 10 years and grow at a rate below 7%, then we would
well, but this may be due to inventory readjustment and the consider this a ‘hard landing’. In any case, exports are still highly
disruption of supply chains with Japan. competitive and could compensate for weakness elsewhere if the
current policies do not succeed.
Hard or soft landing?
Recent data points to the Chinese economy going through a ‘soft In the short-term, despite some risks to the downside, we believe
patch’, creating fears of a ‘hard landing’, should government a peaking of inflationary pressures would enable the authorities
policy not address this adequately. The market’s view is that, to somewhat relax policies by the year end, leading to a potential
in an environment of slowing growth and sustained inflation, GDP growth of 9% for 2011.
the government will pursue tighter monetary policies and other
administrative measures that could seriously dampen an already Inflation is key
slowing economy. The inflation problem in China is primarily related to food prices
– they account for 70% of the CPI increase1 – and both long-term
However, it is worth remembering that interest rates and reserve structural factors (wealth effects) and weather-related ones can
requirement ratios (RRR) in China are used, in part, to exert influence this. We would expect food inflation to peak at some
pressure on the banking sector and sterilise foreign inflows - stage soon, notwithstanding weather effects. On a sequential
rather than as ‘whole economy’ measures. Loan creation is basis (MoM), we are already seeing flat to negative food price
expected to continue apace this year, with up to RMB 7 trn of new inflation, and there is also a base effect that should improve
loans created. Monetary expansion is still higher than nominal going into the third quarter: CPI inflation started accelerating
GDP growth, so there is little problem with credit growth in the sharply in Q3 and Q4 of last year.
Chinese economy, and we expect investments to resume by Q4, Few central banks in emerging markets are in an enviable
especially in areas such as high-speed railways. position today, as inflation and rising costs are putting pressure on
HFT Investment Management’s economic forecasts for 2011
2007 A 2008 A 2009 A 2010 A 2011 E 2007 A 2008 A 2009 A 2010 A 2011 E
Real GDP y-y% 11.9 9.6 9.1 10.3 9.4 Total Loan y-y% 16.1 18.8 31.7 19.9 15.5
Fixed asset invesment 21.1 15.8 33.7 24.5 19.8 Increase in new 3,632 4,910 9,590 7,920 7,420
y-y% lending (bn Rmb)
Retail sales (nominal) 16.8 21.6 15.5 18.4 17.6 M2 y-y% 16.7 17.8 27.7 19.7 16.1
1-yr lerding rate % 7.47 5.31 5.31 5.81 6.55
Export growth y-y% 25.7 17.2 -16.0 31.3 19.9
1-yr deposite rate % 4.14 2.25 2.25 2.75 3.50
Import growth y-y% 20.8 18.5 -11.2 38.7 25.5
RMB/US$ (year-end) 7.30 6.85 6.83 6.62 6.34
Trade surplus (bn$) 262.2 295.5 196.1 183.1 139.5
CPI y-y% 4.8 5.9 -0.7 3.3 4.7
source: HFT IM, May 2011
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domestic consumption just when the post-crisis recovery remains 20% - we do not believe this would constitute a ‘crash’ or
fragile and exports remain under pressure. China’s economic lead to a downward spiral. Chinese property investors are not
growth remains robust, supported by domestic spending, but over-leveraged and have been subject to strict administrative
there remains some slack between current projected growth measures when buying property – more so than in other large
rates and the stated medium-term target. Thus, we believe the economies - even before the latest round of measures took hold.
authorities will continue squeezing inflation, even at the cost of Property construction and its impact on GDP remain positive,
lower growth. especially due to the social housing programme, supported by
local government. However, if residential property prices were to
Although MoM inflation is very hard to predict and most market fall by 15%-20%, as projected, then property investment growth
observers have underestimated its resilience so far this year, we could slow from 30% to 20%, which would have a 1% impact on
expect it to peak in Q4 but believe it may well exceed its current GDP. To some extent, this is already factored in to the equity
5%-5.5% rate on a year-on-year basis. valuations of property companies and we continue to favour the
sector on a selective basis.
Is policy tightening effective?
As mentioned, China has used a mix of administrative measures Equity market outlook
to fight inflation, targeting different parts of the economy. The Most recently the market has taken solace from Premier Wen’s
authorities, particularly concerned with property price increases, upbeat comments, predicting that the battle on inflation had
have used such measures to reduce speculation in the residential largely been fought and won. This may remain the ‘swing factor’
property sector while encouraging the development of housing for market sentiment for the time being. We remain cautious on
stock (10 mn social housing units), thereby safeguarding its the Chinese equity market this year as the above macro-economic
contribution to overall economic growth and supporting the factors have definitely weighed on sentiment and we do not
building materials sector so far this year. Real interest rates in predict a significant rebound as long as interest rates continue
China, as elsewhere, remain negative, which means that further to rise – this is in line with past behaviour observed in the China
rises in lending rates are likely – at least another two 0.25% rises A share market. Our long-term view is however positive at these
are widely expected before year-end. Lastly, with the trade surplus levels of valuation. Over the long term, equities should be driven
continuing to surprise on the upside, increasing the RRR to above by earnings as corporate profitability for Chinese companies has
record levels, this may be used to control foreign inflows. been very strong. Lastly, the demand/supply balance continues
to be a negative factor for the market, with record issuance,
The question here is whether there is a bubble in the property especially IPOs, and an overhang from the banking sector due to
market and whether prices will deflate rapidly. Firstly, we do not more stringent capital requirements. In this environment we are
believe the Chinese property market is comparable to markets looking for visibility in areas such as building materials, which
such as in the US. Prices have risen sharply in the last two years, is supported by the government’s social housing programme
but recent administrative controls seem to have been successful and remain very positive on the healthcare sector (medical
in lowering demand and average sale prices. The authorities’ equipment and pharmaceuticals), which should continue to
objective is to reduce average selling prices by around 15%- benefit from government reform.
1 According to UBS Research
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GLOBAL FIXED INCOME
Portfolio Manager - Global Rates, FFTW
Globalisation’s impact on developed market
Developed markets are now importing inflation instead of disinflation from emerging markets. This trend of
rising global inflation, combined with highly accommodative money policies, will create an environment that
supports inflation-linked bonds. We illustrate our case using the UK as an example.
Low-cost era comes to an end True, the higher-than-target inflation can be attributed to a
About a year ago, the risks of deflation were significant enough VAT increase at the beginning of this year, the on-going pass-
that, in the US, the Fed re-engaged in quantitative easing (QE2). through effects of depreciation in the pound in 2007 and 2008
One of the goals, if not the only goal, of QE2 was to shock on imported goods, and the recent rise in energy and food prices,
inflation expectations higher. On 30 June 2011, QE2 ended and which can arguably be categorised as transitory. This enabled the
both market-based indicators (such as inflation option prices) BoE to focus its policy communication on the lack of evidence of
and survey-based inflation expectation measures suggest that ‘second-round’ effects (as real wage growth remains negative),
the Fed has successfully averted deflation. Some argue that on domestically-generated inflation (which remains low), and on
the Fed not only lifted domestic inflation expectations higher, inflation expectations (which remain relatively well anchored).
but also exported monetary policy accommodation to emerging
economies via their exchange rate regimes, encouraging inflation Asymmetric reaction to inflation
there. The BoE’s inaction in the face of recent inflation data showed
that its reaction towards inflation is asymmetric: its focus is
Monetary policy is not the only link between developed market tilted towards domestic inflation, and it will allow inflation to
(DM) inflation and emerging market (EM) inflation. Over the last deviate from its target quite a lot, both in terms of magnitude
few decades, the vast supply of cheap labour from EM countries and duration.
lowered imported consumer good prices in DM countries. Core
goods inflation fell from around 4% in the early 1990s, to around EMs, as we noted above, are transitioning from exporting
0% in the US and around -2% in the UK in 2000-2010. Now that disinflation to exporting inflation. The shift in this structural
so much global manufacturing is concentrated in EM, especially trend, combined with struggling labour markets in the developed
in China, the cost savings from shifting production to lower-cost world, suggest an increased likelihood of rising overall price
EM countries are diminishing. levels while domestically-generated inflation stays low. In the
face of austere fiscal policies, and financial markets’ fragility, it is
Not only are wages rising in EMs, but the gradual rebalancing reasonable to expect the BoE to stay accommodative, as long as
within EM countries from a heavy export bias to greater domestic domestically-generated inflation remains moderate and provides
consumption is also driving commodity and food prices higher. the BoE with the cover to do so. We may even be witnessing a
It is perhaps not surprising to hear warnings from Wal-Mart, or regime shift in the way the BoE approaches its price stability
the biggest sourcing agent, Li & Fung, that the era of low-cost is mandate…
coming to an end. In fact, these structural transitions suggest
that the rise in commodity, food and manufactured goods prices Investment solutions
could signal an upward trend rather than a one-off relative Some economists are sceptical about the BoE’s approach and
price adjustment. Thus, globalisation is shifting from being are beginning to question its inflation credibility. Inflation is no
disinflationary to increasingly inflationary for DMs. doubt a significant worry for fixed income investors. Fortunately
though, the current environment is favourable for developed
Implication for inflation targeting market inflation-linked bonds which will ensure their investors’
The disinflationary benefits from globalisation in the last two purchasing power is not eroded over time. Above-target headline
decades helped DM central banks achieve stable inflation. The inflation rates will enhance returns via inflation accretion and
Bank of England (BoE) Governor dubbed this period as “NICE”– accommodative money policy biases will likely limit the rise in
non-inflationary consistent expansion. There is evidence that the level of real yields, especially relative to that of nominal
the NICE period is over: despite weak economic growth, UK yields.
inflation has overshot the bank’s 2% target since December 2009, So by taking some exposure to inflation-linked bonds investors
exceeding the 3% upper target-band for the fifteenth consecutive can protect themselves from the threat or rising inflation which
month and is forecast to reach 5% in the next few months. we believe is likely over the next few years.
For professional investors
9 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
Head of International Equity Investments
Japan: after the pain, the healing
After a dramatic reaction to the 11 March disaster, Japanese economic indicators have recently started to
normalise and look generally reassuring for the underlying trend in activity. June turned out to be the market’s
first positive month since the earthquake.
Economic indicators gradually improving This improvement allowed the Japanese market to do a little
Japan’s trade balance continues to suffer on both sides: exports, better (in local currency terms) than its peers in June. Our large
due to the strong yen and the damage to production facilities, cap strategy continued to stabilise after the strong performance
and imports, boosted by the need for energy as coal or oil-fired recorded in March. As in April and May, our June performance
power plants are being used to replace the missing nuclear was very close to that of the index.
Marginal portfolio adjustments in recent months
Outside of this, many of the indicators are rather positive. Of Our portfolio has remained rather stable, but we sold a carmaker
course, the capacity utilisation rate remains low and inventories (to take profits) and a shipping company (due to a less favourable
high, but this was not unexpected given the supply chain issues environment in Asia and excess capacity in the industry). Both
in vehicle production and other industries. The quarterly TanKan of these holdings were replaced by financials. One of these
survey was roughly unchanged, however there were the first reinforced our exposure to the favourable pricing conditions
positive signs of a reconstruction-related recovery in capital expected in the insurance industry. The other one is a bank
expenditure. The Small Business Confidence index (still off its involved in major restructuring to better leverage the favourable
pre-quake levels, but much closer) and the Economy Watchers lending environment and better risk visibility.
survey, as well as Industrial Production and the All Industry
Activity index, are also trending better. End of deflation a catalyst to buy Japan’s cheap equity
Unemployment is down to 4.5%, with labour cash earnings again We do not expect economic activity to accelerate dramatically
up year-on-year. Consumer confidence remains weak but has in Japan in the foreseeable future, despite the benefits of the
started to rebound slightly, and the most recent retail indicators post-quake reconstruction. The government’s support will take
suggest that sales are close to pre-quake levels. too much time and the strong yen remains an obstacle.
Of all the positive points, the moderation in deflation is probably However, we view the recent indicators as a sign that underlying
the most important. While wholesale price variations returned activity remains as resilient as could reasonably be expected.
to positive territory for a while, even the CPI ex-food and energy Given the gradual resolution of production issues, and the fact
(which excludes two of the components which had been the most that oil prices have fallen, things should continue to improve in
subject to inflation recently) now points to a very slight rise in the future.
prices on an annual basis.
We also believe that the stabilisation of the CPI ex-food and
It is also increasingly clear that reconstruction is progressing energy is great news. This price index has been declining almost
well, thanks to companies’ proactive response to the disaster. every month for more than 10 years, with the exception of a
The efforts to save energy have helped avoid any massive power short-lived, mild inflationary period in summer 2008. A durable
outages so far, damages are being repaired and alternative return to positive territory could be a catalyst to unlock domestic
solutions found to resume production as soon as possible. In spending, which has remained depressed for so long in Japan.
addition, companies are now focusing their communication on
how soon they expect things to be back to normal. Finally, at hardly more than 13 times forward earnings, the
Japanese market remains quite cheap and may be considered
This, unfortunately, remains in sharp contrast to the politicians’ an attractive option for investors seeking to reallocate assets
inability to agree on a decent plan to support reconstruction. towards an asset class with higher-potential.
For professional investors
10 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
Raul Leote de Carvalho
Financial Engineering – Head of Quantitative Strategies and Research
Demystifying risk-based strategies for equity
Risk-based approaches for equity portfolios have been outperforming the market capitalisation index for
many years. And if that wasn’t enough, they have been doing it with lower volatility - enough to raise any
investor’s eyebrow. In this article we introduce you to these systematic quantitative strategies and explain
where the risks lie and where performance comes from.
What are risk-based strategies?
Equity risk-based strategies are systematic quantitative However, there is evidence that CAPM has been violated. Haugen3
approaches to stock allocation which rely only on risk views. The showed that low volatility stocks can have higher returns than
portfolios are periodically rebalanced to reflect a change in views. expected by CAPM, and Fama and French4 showed that small cap
The simplest of these strategies is based on the equally-weighed stocks and value stocks also have abnormally high performance.
portfolio (EW) which simply follows the principle of not putting These violations of CAPM are known as pricing anomalies. Active
all your eggs in one basket. The portfolio invests the same amount management thrives on the idea that CAPM is not valid and that
in each stock and makes sense if we believe that neither stock active managers can outperform the market cap index.
returns nor risk can be forecast.
How have they behaved in the past?
The equal-risk budget (ERB) strategy invests in portfolios with the We have run simulations using weekly returns for all stocks in
same risk budget for each stock (which is defined as the product of the developed world going back to 1995 and avoiding survivorship
the stock’s weight to its volatility). Risk is equally distributed among bias. We simulated the performance of the strategies with
the stocks and hence riskier stocks get smaller weights. This can be quarterly rebalancing. At each rebalancing we estimate the
seen as an extension of EW if we trust volatility forecasts. covariance matrix from a standard statistical risk model based
on principal components, which uses two years of historical
If correlations are also taken into account, then we can think in returns. EW and ERB are long-only by construction. We keep the
terms of equal-risk contribution1 (ERC), where the contribution ERC solution with positive weights. For MV and MD we imposed
to risk from each stock is the same. Unlike the risk budget, a long-only constraint.
the contribution to risk (defined as the product of the stock’s
weight to its marginal risk) also takes into account the impact The results in table 1 show that since 1995 all strategies
of correlations. The contribution to portfolio risk from two stocks outperformed the market cap index and all, bar EW, have lower
of the same volatility but different correlations is higher for volatility. MV had the lowest ex-post volatility while MV and MD
the stock with higher correlations and hence it gets a smaller had a high tracking error against the market cap index and only
weight in ERC. These three strategies assume diversification invested in about 120 stocks out of 1700. The other three invested
can be achieved by equally allocating wealth or risk across the in the entire investment universe and had a lower tracking error.
investment universe. Turnover of MV and MD was comparable and much higher than
for the other strategies. MV and MD are defensive strategies with
Minimum variance2 (MV) invests in the portfolio with the lowest a small beta of only 0.4 and 0.5.
ex-ante volatility. The MV is the least risky approach to investing
in equities and is expected to deliver the lowest volatility over MV and MD have the smallest drawdown. However, and even if
time. It uses volatilities and correlations as inputs and invests in they seem to outperform the market cap index in the long-term,
stocks with the lowest volatility and low correlations. they can underperform in shorter periods by as much as 50% and
40%, respectively. This was the case in the late 1990s when it
The maximum diversification 3 (MD) strategy invests in the would have been difficult to beat the bull market. All risk-based
portfolio which maximises a diversification ratio. This ratio strategies would have generated positive returns over that period
measures the amount of diversification in a portfolio by comparing but would have failed to outperform the market cap index.
the sum of each stock’s risk budget to the actual portfolio
volatility. This strategy invests in stocks with low correlations. In table 2 we show the correlations of weekly excess returns
over market cap for these strategies. Excess returns for EW were
What does financial theory tell us? 88% correlated with those from ERB, which in turn were 97%
According to the Capital Asset Pricing Model (CAPM), where stock correlated with ERC. The correlation between excess returns of
returns are proportional to stock beta, the market cap portfolio MV and MD was 96%. This clearly confirms that much is shared
is the most diversified and should have the highest risk-adjusted among EW, ERB and ERC, and similarly between MV and MD.
return. None of the approaches above would make sense as an
alternative to the market cap index if we believe in CAPM.
For professional investors
11 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
Where does performance/risk originate? Table 1: Results from the back-tests of the different strategies.
The Fama and French4 approach regresses a strategy’s excess
returns over the market cap index based on the returns of three Jan-95 through Dec-10 MC EW ERB ERC MD MV
factors: the market cap index over cash, the SMB factor (a portfolio Excess return over Cash 3.2% 6.2% 6.5% 6.5% 5.4% 5.8%
long small caps and short large caps) and the HML factor (a Volatility (ex-post) 17.3% 17.3% 15.7% 14.8% 11.0% 9.5%
portfolio long high book-to-market stocks and short low book-to-
Sharpe ratio 0.19 0.36 0.42 0.44 0.49 0.62
Excess return over Market Cap 3.0% 3.3% 3.2% 2.2% 2.6%
Fama-French factors are not sufficient to explain these strategies Tracking error (ex-post) 4.9% 5.1% 5.8% 11.5% 12.5%
that focus on diversification and invest in stocks with low volatility Information ratio 0.61 0.65 0.56 0.19 0.21
or correlations. Thus, we added two new factors: LBMHB (a portfolio
Max drawdown -56% -58% -55% -53% -39% -29%
long low beta stocks and short high beta stocks and LVMHV (a
portfolio long low residual volatility stocks and short high residual Max drawdown vs Market Cap -23% -28% -28% -38% -41%
volatility stocks). The beta in LBMHB and LVMHV is neutralised by Beta 0.96 0.87 0.81 0.48 0.39
reducing the size of the short leg. Average annual turnover 39% 37% 42% 162% 152%
Average number of stocks 1746 1746 1745 1740 134 111
The regression results in table 3 show that all strategies can be
explained by exposure to these factors. R-squares are in excess of
80% and intercepts are near zero. EW is explained by an exposure Table 2: Correlations of excess returns over the market cap index
to small cap stocks. ERB is less exposed to small cap stocks but is
also exposed to low beta stocks. ERC is even more exposed to low EW ERB ERC MD MV
beta stocks and less to small cap stocks. ERB is a defensive strategy
EW 100% 88% 79% 33% 25%
with beta less than 1. ERC is even more defensive. MV and MD are
both very exposed to low beta stocks and are both defensive with ERB 88% 100% 97% 61% 57%
very low beta. They differ only in their exposure to low residual ERC 79% 97% 100% 75% 71%
volatility stocks, higher in MV than in MD. MD 33% 61% 75% 100% 96%
MV 25% 57% 71% 96% 100%
What to expect in the future
Risk-based strategies are defensive active strategies which have
outperformed the market cap index with lower volatility. Their Table 3: Regression coefficients and R-square from the regression
future performance and risk will depend on how the factors behind of the excess returns over market cap index against the five
the variation of their excess returns behave. We see no reason why factors mentioned in the text. Jan 1997 to Dec 2010.
they should behave differently in the future.
EW ERB ERC MD MV
(Intercept) 0.000 0.000 0.000 0.000 0.000
Market Cap - Cash -0.013 -0.119 -0.200 -0.629 -0.708
SMB 0.373 0.315 0.260 0.059 0.025
HML 0.135 0.155 0.149 -0.040 -0.020
1. S. Maillard, Th. Roncalli and J. Teilietche, Journal of Portfolio Management 36, 4 (2010) LBMHB 0.060 0.160 0.241 0.567 0.543
2. R. A. Haugen and N. L. Baker, Journal of Portfolio Management 19, 3 (1991)
LVMHV -0.019 0.090 0.053 0.044 0.124
3. Y. Choueifaty and Y. Coignard, Journal of Portfolio Management 35, 1 (2008)
R-square 75% 79% 84% 78% 84%
4. E. F. Fama and K. R. French, Journal of Finance 47, 2 (1992)
12 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
Gilles Guérin Denis Panel
CEO, THEAM CIO, THEAM
THEAM: Flexibility, innovation and simplicity
THEAM, our latest partner, offers investors faced with volatile markets and changing regulations, a single
entry point for access to four areas of expertise: index-based management, active systematic management,
guaranteed and protected management, and alternative management. Gilles Guérin and Denis Panel, the
THEAM CEO and CIO respectively, answer our questions on how they can help clients in turbulent times.
PERSPECTIVES (P): Can you describe THEAM to us in a few words? P: What, in your opinion, are the future growth areas?
Gilles Guérin (GG): THEAM results from the convergence of DP: We believe that guaranteed and protected asset management
two complementary universes, Investment Banking and Asset are a major growth area, and with our expertise covering a broad
Management, a merger that provides unique opportunity for range of asset classes, we feel equipped to meet the varied needs
investors to access a vast range of investment solutions. In recent of our clients : from formula funds for banks’ retail clients to
years, with the changing economic and regulatory environment, customised solutions for institutionals, such as our ‘Solvency II’
investors’ expectations have evolved: they expect us to bring them offer which helps insurers optimise their market exposure while
innovative solutions, in terms of both investment strategies and limiting the use of their capital. We think innovation will bring
vehicles. some answers to tomorrow’s challenges and we work closely with
our clients to design these solutions.
THEAM was established by combining the SIGMA teams of BNPP
AM and the teams of Harewood AM. This new partner, with a GG: Another growth area is alternative multi-management.
staff of 120 people, is supported by the research capability of Investors want alternative management solutions that are
BNP Paribas CIB and benefits from the sales forces of BNPP IP transparent and liquid, and more generally, in line with their
and BNPP CIB. At present we have about EUR 50 billion in assets constraints: we offer them a ‘managed account’ which can be
under management1. The main challenge, in our opinion, is to valued on a daily, weekly or monthly basis depending on clients’
provide our clients with turnkey solutions to allow them to focus constraints or wishes. As a reminder, managed accounts are
their efforts on their strategic allocation. designed to replicate hedge-fund strategies, while providing
investors with greater liquidity, transparency and increased risk
P: In concrete terms, what solutions do you offer investors? control. From this viewpoint, our partnership with INNOCAP - the
managed account platform of our Canadian partner- enables us
Denis Panel (DP): The THEAM offer is organised around the to precisely tailor solutions to fit investors’ needs. For example,
four management pillars of index-based management, active investors can choose to exclude from the selected investment
systematic management, guaranteed and protected management, universe one or more funds which do not meet their requirements
and alternative management. or constraints.
In index-based management, our selective offer is focused on P: To conclude, what are the advantages of THEAM for an
a few leading indices such as the Euro Stoxx 50 and the Epra institutional investor?
Eurozone (real estate). We also build customised solutions, in
various formats - ETFs, funds, mandates -, to meet specific GG: THEAM is primarily a single entry point for our clients
needs: socially responsible or Sharia-compliant investments, enabling them to obtain exposure to all types of assets, from the
etc. Regarding index replication techniques, our approach is most conventional to the most sophisticated. We use all types
pragmatic: we select the replication method most appropriate for of investment strategies - beta, discretionary and systematic
the underlying index, taking into account cost constraints. alpha, assemblies of external alternative strategies - in a very
transparent approach. We also provide our clients with cutting-
Through active systematic management our clients benefit from edge expertise, notably in the areas of guarantee/protection and
our significant quantitative research capabilities, especially quantitative strategies. This customised approach also extends
research by our investment banking teams. Our expertise, to risk management, which we adapt to the requirements of
namely in developing trend follower and mean reversion each investor. Clients can also benefit from great flexibility in
algorithms, enables us to provide our clients with exposure both terms of investment vehicle format and from our recognised
to conventional shares and bonds and to less traditional asset expertise. Accordingly we have a large number of tools to meet the
classes such as volatility, commodities and correlation. Our requirements of the most demanding and innovative investors.
investment management, which involves a discretionary aspect,
is characterised by a strong quantitative dominant, thus adding
value for clients in a different way to fundamental management. 1. Source: THEAM. Data as at end March 2011.
For professional investors
13 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
14 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
pertise investment capab
& regional solution
15 - BNP Paribas Investment Partners - PERSPECTIVES - July/August 2011
This material is issued and has been prepared by BNP Paribas Asset Management S.A.S. (“BNPP AM”)* a member of BNP Paribas Investment
Partners (BNPP IP)**.
This material is produced for information purposes only and does not constitute:
1 an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment
2 any investment advice.
Opinions included in this material constitute the judgment of BNPP AM at the time specified and may be subject to change without notice.
BNPP AM is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal
and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make
an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of
investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment
may either be suitable, appropriate or profitable for a client or prospective client’s investment portfolio.
Given the economic and market risks, there can be no assurance that any investment strategy or strategies mentioned herein will achieve
its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial
Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The
different strategies applied to the Financial Instruments may have a significant effect on the results portrayed in this material. The value of
an investment account may decline as well as rise. Investors may not get back the amount they originally invested.
The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and
redemption and taxes.
*BNPP AM is an investment manager registered with the “Autorité des marchés financiers” in France under number 96-02, a simplified
joint stock company with a capital of 64,931,168 euros with its registered office at 1, boulevard Haussmann 75009 Paris, France, RCS Paris
319 378 832. www.bnpparibas-am.com.
** “BNP Paribas Investment Partners” is the global brand name of the BNP Paribas group’s asset management services. The individual asset
management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily
carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.
Publisher: Philippe Marchessaux
Editor in Chief: Anthony Finan
Deputy Editor: Maryelle Ouvrard
Publication coordinator: Sandrine Bensussen
Graphic design: Studio Graphique BNPP IP
Translations: Tectrad, CPW Willemetz
A global presence
July/August 2011 - Design: Studio BNPP IP - P1107019
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