What buying opportunies have been created by the eurozone crisis?

Equities

Didier Duret, Chief Investment Officer, ABN Amro Private Banking

Risk related to the European Monetary Union (EMU) has cast an overwhelmingly dark cloud over global financial markets, temporarily hiding genuine value created by private companies.

Recognising the risk in the current make-it-or-break-it context must not lead to investor paralysis. We know that acting on volatile news generates underperformance in the medium term. One also has to take into account that fears of a global recession are accelerating initiatives that aim to address EMU flaws. The euro will survive, but in the absence of a swift and unified eurozone growth roadmap, a lower euro and oil price could mitigate recessionary forces in Europe and represent a market game changer.

Negative real yields on the safest bonds call for a strong underrepresentation of government bonds and commodities. The quest for steady income can be satisfied with corporate bonds. The capacity of hedge funds to withstand macro and political risks make the case for their overrepresentation in asset allocation. Neutral positions in equities and real estate offer the possibility of benefitting from the positive impact of policymakers’ actions. This is no time for passive asset allocation.

Investors should first focus on cash-rich private companies that follow “megatrends” such as the energy revolution, care industry or the new age of services. Companies such as DSM, BASF and Samsung offer resilience in any portfolio, trading with a 12-month forward price to earnings ratio (P/E) below 10.

S&P earnings are 15 per cent higher and P/E is 30 per cent lower than at previous levels in 2007. Global property is offering attractive valuations, with 15 per cent discounts to NAV and 4 per cent average dividend yields.

Forced selling has made (private equity) secondary buyouts attractive; small to mid-market emerging-market funds and venture capital funds of funds are also appealing due to the shrinking pool of investable assets.

The possibility of a lower euro could strengthen the case for discounted European equities, with Germany, Benelux, Switzerland and Nordic countries preferred.

The recent correction in Brazilian equities provides an entry point, with high dividend yields and compelling valuations, considering the central bank has ample firepower to stabilise the Brazilian real at around 2 against the US dollar.

A new wave of stimulation in Asia is creating opportunities to position in China, but also in countries with plans to stimulate their domestic economies, such as Malaysia and Thailand.

On the fixed-income side, widening spreads offer an opportunity to concentrate allocation in high-quality corporate bonds and diversify with Asian corporate bonds such as Hutchinson Wampoa. It is also an opportunity to accumulate US high-yield bonds. EMU benchmark funds can provide diversification through active fund managers investing in peripheral bonds.

Hedge fund manager views are less clouded by general investor sentiment while being very focused on – or diverging from – economic circumstances or asset classes. Hedge funds in the space of global macro, CTA and relative value strategies provide insurance against macro and policy risks.

The crisis has created a new breed of managers, highly conscious of tail risk-hedging and able to work with low leverage.

Interestingly, if we look at the correlation matrix of hedge funds, CTA and macro have flat to negative correlation with various bond buckets and show low correlation with equity markets.

The reality of investing today is that risks can’t be categorised – investment opportunities must be judged on their own merits. The notion of a safe haven is relative in light of the current debt mountain, as is equity risk, considering the cash flows generated.

Alan Higgins, Coutts

Bonds

Alan Higgins, Chief investment officer, Coutts private bank

The prolonged eurozone debt crisis has heightened risk-aversion. While the threat of a Greek exit from the single currency has abated following the re-run election, the Spanish banking system remains under threat and disappointing global economic data is weighing on sentiment. Western central banks remain in ‘wait and see’ mode over further monetary stimulus.

The crisis has driven a flight to ‘safe haven’ assets such as high-quality government bonds. This has pushed their yields to record lows, creating a dilemma for investors. In the past, conservative investors could count on such bonds to provide portfolio ‘ballast’, which would hold its value during market turbulence while generating returns at or near inflation to protect purchasing power.

With some bonds now yielding below inflation, these ‘safe’ assets no longer provide long-term capital protection, albeit the ‘ballast’ feature remains intact shorter term. Investors who have sacrificed longer-term purchasing power protection in favour of nearer-term capital protection need to look elsewhere for ways to preserve their long-term wealth against this low-yield backdrop.

Investment-grade corporate bonds offer some of the features formerly provided by Western government bonds. In our view, investment-grade corporate bonds (ie, a minimum rating of BBB) are safer than the majority of euro-zone government bonds. While government balance sheets are at the centre of the debt crisis, European non-financial corporates have deleveraged since the beginning of 2009. Despite this, investment-grade corporate bonds in general, offer an attractive yield advantage over government debt, albeit this advantage has been eroded for some of the highest-quality corporate bonds.

Furthermore, our analysis suggests that even if default rates were to reach the worst levels seen over the last 40 years, corporate bonds would still do better if held to maturity than comparable government bonds.

We also highlight opportunities at the higher-quality end of the high-yield bond sector (BB-rated) for investors looking for equity-like exposure, but with lower volatility and greater capital protection. There has been an historical tendency for high-yield bonds to outperform equities during times of slowing or negative growth, albeit the valuations of investment-grade bonds are currently more attractive.

Nevertheless, high-yield bonds are supported by benign default rates and positive trends of debt refinancing and fund flows into the asset class. Although risks of a substantial correction have increased significantly following a very strong start to 2012, we believe prospects for high-yield bonds are attractive in the medium-term.

We would also view high-yield bonds as an attractive near-term alternative to equities. Investors need to be selective, however, as Asian high-yield bonds don’t offer the same broad value that Western high-yield bonds currently do. While investment grade is more important to bond selection than geographies and sectors, we would limit exposure to Europe given its position at the heart of the crisis.

While we remain underweight equities near-term, we are happy to be an early investor on market weakness. Equity valuations are at attractive levels over the longer term but not at ‘deep value’ levels. Longer term, however, we expect rising, policy-led inflation to erode the yield advantage of corporate bonds and once more highlight the attractions of equities.

The eurozone crisis makes investment-grade corporate bonds an attractive near-term alternative to both government bonds and equities. Corporate bonds offer higher yields and stronger balance sheet backing than government bonds, as well as lower volatility and better capital preservation than equities.

While we remain cautious on equities, they are fairly valued relative to historical levels and very good value relative to government bonds. We believe that investors with a long-term horizon and who can stomach higher volatility in the short term should add to equity positions on market weakness.