Client Conversations - A Global Summary

Around the world in 50 days ... Over the past two months, our Portfolio Strategists have had more than 500 one on one meetings across Europe, the Middle East, the US and Asia. These have involved a wide spectrum of investors including pension funds, insurance companies, mutual funds, macro hedge funds, long/short hedge funds and sovereign wealth funds. We have also completed our Global Strategy Conference across Europe, with seminars, group meetings and discussions, seeing more than 1,700 clients in five countries. We thought it would be helpful to summarise some of the questions, concerns and ideas from these conversations. Fear and loathing drives caution US: If we had to identify a takeaway from our meetings, it would be the lack of confidence in financial markets. The bearish outlook repeatedly expressed by many investors, particularly those in Europe, reflected a withering of trust in both public and private financial institutions. Last week, at a dinner hosted by the authors of this report, just four of 20 attendees expected stocks to close higher by year-end. Europe: Global funds seem to be underweight Europe, with US funds in particular focused on the prospects for a deeper and longer European recession and the risks of a euro break-up. Our Overweight UK seems controversial, with a negative consensus on the economy. Our Overweight in retail also seems to get much pushback. Most accounts are defensive, with a negative bias towards banks and deep cyclicals. Asia: Our top-down earnings expectations were our most out-ofconsensus view. Most investors were surprised by the magnitude by which our 2009 top-down earnings forecasts were below consensus: we expect -20% to -35% EPS growth; sell-side consensus currently stands at -2%; and we estimate that the buy-side consensus is now about -10%. Consensus is coming down fast in Taiwan, but remains stubbornly optimistic in Korea in our view. Japan: Our market scenario of “first half weakness, second half recovery” has (uncomfortably) become consensus and, while many believe that valuations look cheap, concerns focus on Japan’s vulnerability to weak export demand and a strong yen suggesting that TOPIX could still test new lows near-term. Many macro funds we met appear to be long yen and increasingly long JGBs. UNITED STATES Our recent travels took us to the West Coast, Midwest and Northeast US, and across Europe. We discussed portfolio strategy and positioning for 2009 with a broad group of mutual funds, hedge funds, insurance companies, endowments, pension funds, pension consultants, CEOs, private bankers and sovereign wealth funds. Lack of confidence. If we had to identify a common takeaway from our meetings it would be the lack of confidence in financial markets. The bearish outlook repeatedly expressed by many investors, particularly those in Europe, reflected a withering of trust in both public and private financials institutions. In the opinion of many investors, corporate executives and policymakers deserve an equal share of the blame for the current state of affairs. Lack of confidence was the key reason cited by portfolio managers for their dim outlook for equity returns in 2009. Last week, at a joint dinner hosted by the four authors of this report, just four of 20 attendees expected stocks to close higher by year-end. Our year-end view is more optimistic than that of most buy-side fund managers but investors seemed to agree with our bearish near-term view for the balance of 1Q2009. We expect the S&P 500 will re-test the November low of 750 before trading higher to our year-end price target of 1100. Negative catalysts to push the market lower include: (1) dismal 4Q2008 earnings results expected (below the bearish consensus); (2) reduced–and in many instances withdrawn–corporate guidance for 2009; (3) the mid-February notification deadline for hedge fund redemptions (our conversations with several pension funds and endowments suggest that further hedge fund redemptions are coming); and (4) a realization that, although fiscal stimulus should be positive for growth, it will not be the cure-all the market seems to anticipate. Most of our client conversations centered on the following three themes: • When to rotate into cyclical stocks. This was by far the most frequent topic of conversation. Many portfolio managers seem to be waiting, trying to decide whether to stay defensive or make a direct move into more cyclical areas of the market. While investors have a decidedly bearish outlook, they also expressed concern they might miss a rotation into cyclical shares. Our response is that asymmetric risk exists in being pro-cyclical too early as downside at the end of the cycle is often meaningful. • Consensus positioning remains defensive. The phrase “Talking Bullish, acting Bearish” comes from a long-time market participant and best captures the current mindset of many investors. Actions speak louder than words. Fund managers all stated that they were overweight defensive stocks. We agree, because the potential “give up” by remaining defensive for longer in consumer staples and healthcare stocks if the market rallies is likely to be modest compared with the outperformance of these sectors in a declining market, in our view. • Risk of nationalization of the US banking sector. Since the inauguration of President Obama, questions about the future of the US banking sector and the possibility of nationalization have become a favorite topic of discussion. Our view is that the US banking system will not be nationalized. However, the Goldman Sachs banking analyst Richard Ramsden discussed in a recent report how big US banks are at risk of being the “new utilities” as the government is now the largest stakeholder (see Capital risk now, utility risk later; re-launching on large cap banks with a Cautious view, January 26, 2009). Government loss-sharing arrangements are likely to continue in order to provide a floor for assets on balance sheets. We believe loss sharing will come before asset purchases despite the fact that the “bad” or “aggregator” bank idea is clearly dominant at the moment. In fact, there may be a temptation to guarantee assets rather than buy them, given that a guarantee does not require borrowing and a large upfront capital commitment.