Equity Outlook

In the current environment, the cost of investing in equities is really low. This means that the risk premium on equities is very high. We believe we should see a price/earnings multiple expansion of equities in the US and an even higher one in Europe. On top of this, the US economy should accelerate in the coming years due to increased investment (energy costs and productivity are attractive) and consumption (wealth effect due to better real estate market, equity markets and, of course, job market).

Even if Q2 is quite weak, we see some kind of rebound of activity in H2, especially in the USA as the American economy should regain the title of “engine” of the global economy (going forward to 2014).

Sector rotation towards underperforming sectors

In Europe, some cyclical names should do better going forward. Some banks are still deep value and should benefit from further restructuration (KBC, Lloyds ING, …). After some profit-taking at the start of the year, IT software should perform well going further. Energy has a major capex issue and should continue to underperform. Mining has a capex issue as well, but some companies are now more disciplined and should rerate (e.g., Rio Tinto). Utilities still have a cash flow issue (high costs, structural low demand) and we do not see any upside there for the moment. In the US, domestic cyclical segments have already performed (e.g., banks) and should continue to do so due to an acceleration of the economy in the second half of the year and next year.

Defensive stocks

Although European Telecom and Utilities companies are not expensive, they do have structural issues and, as a consequence, a lack of growth and profitability. In the USA, the Telecom sector is a better choice as the market is more concentrated. Pharma on both sides of the Atlantic is still attractive in our valuation models (based on discounted free cash flows). The sector, after more than a decade of issues (generics, FDA, bad cost management) is now in better shape and showing a nice profitable growth profile. As for Food & beverages and HPC, these sectors have a better profile in terms of cash generation, with an even better risk profile.

Irrespective of the weak macro-economic figures, a disappointing results season and the persisting crisis in the Eurozone, the equity markets are, surprisingly enough, more than holding their own. With the bond markets currently at an all-time high and the equity markets dirt cheap, the long-term bear market could well be coming to an end.

With the first six months of 2012 now behind us, we can say without a shadow of a doubt that it really was quite an eventful H1. Following a particularly strong first quarter, stimulated by the revival of economic momentum and better, ECB-driven market liquidity, the equity markets underwent a sharp correction in Q2. The effects of the 3-year LTRO petered out, putting an end to a classic liquidity rally. In the meantime, the eurocrisis flared up again, with Greece one of the main protagonists. An eventual ‘Grexit’ made investors cautious and the financial markets more nervous, even before Spain insinuated its way back into the headlines. The Spanish banking sector was having a tough time of it and required support from the European Union, while Bankia – the country’s fourth-largest bank – was nationalised. The stock markets then plunged in April and May. Only after these two difficult months were the markets able to make up some of the lost ground in June, a recovery that was to stretch into the summer months.

A hope-driven rally

The current stabilisation and strength of the financial markets is, however, driven mainly by the odd reassuring news report and a large dose of hope. The markets are already partly taking into account the monetary easing promulgated by China, the United States and even by the European Central Bank. The market is, consequently, in the shorter term, dependent on liquidity, an early catalyser of the stock market rally.

It is, however, currently too early to celebrate a lasting market recovery, as we have as yet achieved no structural reduction of the risk premium in Europe. Investors will only accept lower risk premiums if there is an abatement of uncertainty and of the risk that the European debt crisis is bringing in its wake. Although a number of interesting projects have already been launched, such as the creation of a European debt redemption fund and a banking union, fiscal integration will require more time. Each disappointment could result in a new cycle of stress, the biggest driver of European negotiations. The psychological struggle among the different European countries is encouraging rumor and volatility in the markets.

“Hope” is, however, possibly not the only reason for our sustained perseverance on the equity markets. Although the past twelve years are not immediately considered as the most fruitful of years for the equity investor, we may be witnessing signs of a sustainable bull market. The benchmark for the European equity market – the Eurostoxx 50 – is more than 50% lower than it was 12 years ago (see graph).

The equity markets have, in the meantime, dealt with the actual excesses, undergoing a substantial de-rating into the bargain. Going back to the S&P 500 data (the most available), we have established that the equity market has, since the start of the secular bull market in 2000, lost more than 12% of its value. The drop did not occur overnight – it came complete with the necessary volatility and bear rallies. The price-earnings ratio consequently fell from more than 30 back to almost 13 in comparison with a long-term average of over 16 (Bloomberg data since 1954), even though that should not be put down uniquely to the rate relapse. Indeed, company profits over the past twelve years have substantially improved (see graph: S&P 500 profit evolution). The average annual growth percentage of company profits within the S&P 500 came to more than 5%, even after the drop in profits during the internet bubble and the Great Recession of 2008-2009. That level of profitability is not yet shown in the changes in company price/book values.

 

 

 

Equity fall from grace

It is clear that, in investors’ eyes, the equity markets, since 2000, have come up short. Various indicators point to a hitherto unknown level of pessimism, e.g., Bank of America Merrill Lynch’s ‘sell side indicator’ (which is based on a survey of market strategies on Wall Street that disclose their allocation recommendations, with conclusions about market optimism/pessimism drawn on the basis of the average equity weightings in the allocation recommendations) is at its lowest since 1998. Over and above that, it would appear from the latest Bank of America Merrill Lynch Fund Manager Survey that the cash percentage is very close to last year’s highest levels. Both indicators are good counter-indicators.

In addition, the equity markets, for the first time in more than 50 years (with the exception of 2008), are yielding higher average dividend returns than the rate an investor can expect on a 10Y US treasury. The attractiveness of equities versus bonds is also seen in a comparison of the earnings yield with the interest on “risk-free” government bonds. The surplus return (earnings yield less risk-free interest) for the US equity markets exceeds 5% and even, in Europe, 6%.

Obviously, whoever, these days, makes long-term investments on the equity markets will probably have nothing to moan about over the next few years. With an all-time high in profitability levels and historically low valuation, equities are once again flavour of the month, especially when compared with the historically low interest. The huge difference in valuation between government bonds and equities, indeed, indicates risk for bonds in most scenarios. Investors capable of exercising enough patience and, in the short term, of tolerating a degree of volatility in their equity portfolio, could well end up quids in.

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The Moscow Stock Exchange has increased by 24% since October 2011 after a downward slump. Following the Russian parliamentary elections at end of 2011 and presidential elections in March 2012 where are the Russian economy and the financial markets heading?

The rally in Russian share prices occurred in sync with the global market recovery as investors’ risk appetite resurged. Improved global growth prospects and progress on the European sovereign debt crisis, together with a global monetary policy more lenient than expected lifted all asset classes.

A more and more accessible Russian market 

The Russian equity market remains highly attractive on valuation grounds. In the longer term, Russian growth potential remains huge. Obviously risks abound, and investors remain sceptical for now. With Putin’s re-election, early indications show that the government will proceed on a more populist route, with some limited concessions to the reform/liberal block. Higher taxes for the oil & gas complex can help finance the rising government expenditures, but will not decrease Russia's dependence on high oil prices. Corruption and capital flight still have to be tackled. In the meantime, areas likely to better perform in terms of investments are the beneficiaries of the increased consumer and government spending. A boost to valuations may come later in the year as local equity market trading reforms are gradually introduced, making the Russian market more accessible to (foreign) investors, and turning Moscow into a real financial centre. Planned privatizations, new listings and the scope for a substantial increase in participation of (Russian) institutional investors are all proof of the market's rerating potential.

Sectors to bet on in the future

Consumer and government expenditures are likely to remain the backbone of Russian growth for some time to come. Russian household consumption will continue to grow as disposable incomes rise and the number of people able to afford more expensive items increases.  Food retailers, such as Magnit, which continues to roll out new shops on a weekly basis, are an obvious beneficiary.  But more cyclical players would also benefit form this income surge: for example, the electronics retailer MVideo or real estate developers such as LSR Group.  In addition to rising government expenditures on infrastructure, upcoming international events in Russia, the 2012 Winter Olympics in Sochi and 2018 FIFA World Cup for instance, will in all probability make construction companies, such as Mostotrest benefit from the increased government spending on infrastructure 

Conviction + Discipline = Performance

• Quality of the management and corporate governance
• Clear, sustainable competitive advantage
• Growth of the underlying market
• Cash profitability above cost of capital
• Appropriate financial leverage
• Attractive valuation

​

The launch of a fresh round of quantitative easing in Japan has created a shock effect. The emerging markets will remain under pressure, while the Japanese market is making great strides. In short, Japan is finally worthy of its place in a diversified portfolio.

Impact on the real economy

The key question is, of course, whether the BoJ’s monetary efforts will actually create economic growth and inflation. The substantial recovery of the Japanese market could, in any case, act as a real boost. The direct impact (impact of the rising rates on Japanese household wealth) is fairly limited, given that a mere 7% of Japanese households are invested in equities. The indirect impact could, however, be even greater, as increased consumer confidence could generate greater domestic demand. Japanese monetary policy could also benefit business activity by depreciating the Japanese yen, hard hit by the central bank’s announcement of stimulation measures. Since October 2012, the real rate of the yen has been down by more than 20% in comparison to its main trading partners (30% or so with respect to the euro). This will considerably boost Japanese exports in the coming quarters.

The actual effect of the new support measures is, however, a matter of guesswork. The Bank of England (BoE) report gives us an idea of what’s in store. According to the BoE, quantitative easing of 15%-20% of GDP could increase growth by 1.75% and inflation by just under 1%. The BoJ’s new measures will, therefore, certainly affect Japanese economic growth, due to accelerate this next quarter. The first signs are already visible in the business confidence indicators (Tankan Business Conditions and SME Indicator). In addition, the manufacturing PMI is now, for the second straight month, over 50, the level that separates growth from decline.

Too late to invest?

Equity investors are, in any case, expecting the BoJ measures to have a major impact on the region’s economic momentum. The Merril Lynch Fund Managers Survey indicates that, over the past five years, Japan has been regularly underweighted in most of the balanced portfolios. This trend is now being reversed. Many investors have recently begun to reduce their underweight on Japan in their regional equity allocation, at the expense of their general overweighting of the emerging markets. Here at Dexia Asset Management, we are, for the first time in almost ten years, again overweight on Japan.

This is a trend that should be confirmed by a further improvement in the economic figures. However, not only is the reversal of economic momentum a good reason for investing in Japanese equities: earnings momentum could also offer a considerable boost. The depreciation of the Japanese yen (an export-friendly measure) and a better economic environment are also bound to strongly impact companies’ bottom line. The earnings revision ratio turned positive recently (more upwards revisions than downward revisions) and, in view of the expected improvement in corporate returns (cf., diagram showing Japanese rate/book value and profitability), the region could well be re-rated on the basis of current valuation parameters.

In the medium term, there is clearly further potential on the Japanese market. Following the substantial mid-November rally, the Nikkei 225 now needs to get its breath back; there could, therefore, be a minor correction in the short term. This could prove to be a window of opportunity for investors with diversified portfolios currently not exposed to the region.

Graphic detail

Year-to-date,, the Nikkei is up by around 35%. Regardless, the index is still far from its high of 2007 (the all-time Nikkei high being, incidentally 38,900 points (12/1989)).

With estimated worldwide economic growth of 3.3% in 2013 to 4% in 2014 (IMF), as well as a weaker yen, Japanese exports should accelerate.

The beginning of each of the last 3 years has been market by the hope "This year will be the return of stock picking". And finally at the end of the year, people conclude "this year was all about macro". 2011 won't be so different.

It's not the end of the stock picking even if a buy and hold approach is being challenged for months if not years.

Influence of the macro on the stock selection is a classic and never ending debate. But clearly when correlations are shooting up as this is the case over the last couple of months, this is probably the easiest way to measure the market appetite for macro investing.

Stock picking is always an option in such an environment.  Only macro rules are changing depending on market regime. Investors should be aware of new rules in this "New world" (as highlighted during the last G20 in Cannes).

The last 30 years saw a huge increase in financial leverage across the Western World. Whatever choice Europe goes for, the deleveraging is going on. It's a strong headwind for companies that have benefited from these conditions.

​The develeraring aspect of the new world is well known but investors should also pay attention to another important dimension. A transfer of wealth should be organized from Europe's rentiers to entrepreneurs, to reverse the excess associated with the previous wealth cycle.

By definition a rentier is extracting a lofty return from an established situation, comfortable situation. This is to some extent a Malthusian behavior because a rentier is always minimizing its investment.

Profit generation in the new world is not condemned but will be highly scrutinized and in some cases constraint. Companies will have to show that their profits are tied to innovation, investments and that they are contributing to some form of social utility. This will be a key micro aspect of the political economy in which we will have to live for some time.

• The expectations regarding the European Summit (situation in Greece, recapitalisation plan for banks, improved efficiency of the EFSF, improved governance for the Euro-zone with regards to tax integration)
• The de-multiplication of the EFSF’s power
• China and the risk of a crash landing for its economy (credit, real estate, etc)
• Publication of results, e.g. at Wall Street

 

​Too much noise is hampering a clear market view. Today while it is all about doom and gloom, it is more than ever necessary to take a step back and determine the next prevailing market paradigm or at least market regime.

Buying European equities sounds no longer a question of valuations. Eurozone equity markets are now among the cheapest among all world equity markets. The issue is what political leaders of the Eurozone want to achieve and what message they will deliver in the coming months. The issue is also going beyond the eurozone. It is now up to the politicians in delevoped economies to introduce the fiscal and labour reforms needed to reawaken demand and investment growth. But that is bound to take time.

The overall economic framework in which we will have to operate for the next decade needs a radical rethinking. Belief systems have been shaken and the current political, economic order is simply not sustainable and thus creating a deep crisis of confidence. That's for the long haul.

In the meantime investors need to assess which kind of valuation regime we are heading for, what would be the norm for the next 5 years. There are many similarities between today's market backdrop and what we saw in the late 70s. These include low economic growth, high inflation (stagflation) with a dose of financial stress implying downward pressure on equity valuations.  In both cases we are going through a painful, relentless compression of valuation multiples which is ultimately discouraging market participants to consider equity investments.

At the same time paying european equities at low single digit valuation multiples is striking while inflation is barely exceeding 2.5% and profit margins almost standing at records. 

The current regime of high corporate profitability is contrasting with the unfavourable domestic economic environment and that's precisely the trick. The more corporate are defending their profit margins the more the equity risk premium kept rising. Investors shouldn't be too worried about 2012 operating profits. European companies are accustomed to prolonged period of slow growth with high level of unemployment, thus they will be able to manage well another tough period of time.

But the market is no longer rewarding this ability to extract record profits because it has realized that lofty return on equity cannot coexist with a sustained high double digit rate of unemployment. Investors have discounted that current level of profits won't be sustained in the near future.

The private sector cannot be expected to sustain aggregate demand while it is de leveraring and that governments need to articulate credible and detailed long term programmes to stabilise and then lower public debt. That's the new challenge and corporates will have to pay a portion of the bill.

What kind of valuation equilibrium should be reached in a context where no monetary and fiscal stimuli are anymore possible? Over the last 20 years equity markets (even financial markets generally speaking) have been accustomed to a simple medicine: a big dose of stimulus was injected as soon as equity indexes were falling (the famous put of the FED).

This time is over and this is not necessarily a bad news. At Jackson Hole Bernanke acknowledged honestly that the FED alone is not able to prop up the underlying growth potential and that a new approach was required. A new economic policy should be centered on job creations.

Barring a double dip equity valuation multiples may have reached a stage where this new equilibrium is almost priced in (equity risk premium above 6.5%) but a sustained market appreciation requires a delivery of this new approach.

​I have returned after a two week break and there is so much going on, so many things to say.

Market is bracing itself for a tough Thursday with the release of the ISM manufacturing index, a widely watched leading indicator. Expectations are low with the market expecting a drop to 48 from 50.9 in July, the first sub 50 print since July 2009 and consistent with the weakness in the recent regional surveys.

Only a material deviation from this level would act as a equity market driver. Much has been written about the last Philly Fed, which was a real shocker two weeks ago. The Philly Fed is pointing towards a 42 print.

Last year the market was also expecting a subprint ISM in September and finally the data surprised positively. This is unlikely to be the case today as the gridlock in Washington may have a bigger impact on business and consumer confidence.

I won't try to predict the impeding ISM or NFP.

What I do find more interesting is to look at the US Economic surprise index. This index is more powerful to explain market moves and it has recently turned the corner.

Some ray of light in a gloomy world?

Investors are highly nervous, that is no news. But a full range of things going on are defying the gravity.

Investors are ready to take a calculated loss rather than invest it somewhere else, where the risk of losses is higher. Nothing wrong until that point.

One of the key rule of thumb in all financial textbooks is that there should be a straightforward correlation between risk and reward but it is quiet unusual to see a negative nominal interest rate.

In a perfect world the return equity of the cash should be 0%.

Last week's auction of six month bills resulted in a yield of -1%, the first time that interest rates dropped below zero for Swiss government debt.​ What does it mean?. A bond issued at 101 will be redeemed at 100.

It means that people are paying the Swiss state to lend it money. In some respect parking the cash into a vault is not cost free.

Is this aspect part of the "new normal"? What should be the right price of the liquidity?

The liquidity crisis is coming at a worst time. Most of European banks have completed their refinancing program for 2011 but it is time to turn our eyes to 2012-2013. And the situation is tricky if markets are staying on a dysfunctional mood​.

A huge amount of debt should be refinanced in 2012 and this is a broad base issue. European utilities have for instance to refinance almost € 50 billions of debt. As a whole, this would seem manageable. However, within the sector refinancing is quite concentrated: half of the total is from Southern European utilities only.

Then you got the sovereign debt and regarding Italy or Spain the amount is meaningful. Take a look at the Italian funding program as shown below.

Last but not least we need also to deal with the banking debt.

Given the amount of money which is required to absorb these refinancing needs we need a normal investor appetite or at least a powerful buyer of last resort (central banks).

It is not just a question of fact and figures but also a question of trust and vision to create the foundations for normal capital markets.

Today investors are no longer fooled. Put yourself into their shoes just 2minutes. European leaders initially insisted that there would be no defaults, then said there would be no defaults before 2013 and then when Greek bonds were restructured in July insisted this would be a one off.

Investors see the Greek default coming (priced at 99%). Now they are only concerned by how large losses will be, who will bear them and whether the euro zone has a strategy to limit the contagion. A potential capital shortfall for the banking system alone won't do the trick.

European decision makers should disclose a long term roadmap which should be embraced by the market.  

The vision and capacity to communicate convincingly will be paramount.

Early August I drew your attention on the astonishing evolution of the Swiss franc (read No winter skiing in the Swiss alps this year​).

This morning the Swiss central bank (SNB) announced that a foreign exchange target in EUR/CHF would be in place, with immediate effect.

In today's policy statement, they announced the target would be a minimum of 1.20 and "the SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities". There is no mention of the peg being temporary.

As the consequence the Swiss franc has lost almost 10% in a couple of minutes and is now above 1.20.

This move is not a surprise has Swiss politicians have given the SNB full backing in relevant measures to stop the appreciation of their currency.

This is not the first time in Switzerland's history where an forex target has been adopted. In 1978 the SNB defined a target for the franc against the German mark.

This strategy is inflationary in essence. There is an open question about how much inflation the SNB is willing to tolerate. In 1978 the SNB pushed inflation from 1 to 5% within a year and shortly after that the currency peg was suspended.

The reflation strategy is not dead. Will other central banks join the party?

Safe havens are getting more difficult to find now that the Swiss Franc pegged itself to the €. It has historically been one of the most popular plays. The Swiss National Bank is now keen to depreciate its currency whatever it takes while short term bonds are already providing a negative nominal yield.(read the news 6th of September Swiss strikes back).

What's left? Always the same usual suspects but they are either highly expensive (German Bonds) or fairly illiquid (Norwegian Krona) for sizeable investments. Buying gold close to 2000$ requires some faith but if investors are fully convinced that the end of the world is nigh there is no limit to the gold appreciation.

The search for a safe haven is not guided by the quest of profit but rather the fear of a potential loss. When does it end?

Maybe when US 10 year bond yield will fall to 1.5% with an inflation of 3% while the dividend yield of France Telecom will spike to 15%. A platform for October ?

​

One can easily feel lost in these markets. Traditional thinking is no longer enough to understand market moves.

It is painful but market pressure is maybe a necessary evil​. Germany and its Northern European allies believe that only intense market pressure can force weak economies to cut spending and improve competitiveness.

This process can explain the staggering levels seen recently on the credit market.  They can't be justified by fundamentals at first glance. Italy AA 5 year CDS is trading for instance at 450bps, 50bps wider than Vietnam. France AAA 5 year CDS is trading at 187bps which is wider than Indonesia and hardly tighter than Russia.

While there is a global stand off between financial markets and governments, the trouble in Europe is that politicians think they can fool the market. Greece has learned that whenever the crisis in Europe's periphery threatens to overwhelm the core, Europe will ignore previous broken promises and step up with a fresh bailout. It sounds that Italy is making the same calculation. Italy's disease which is very much a slow growth economy has been a long standing issue but it refused to undertake the structural reforms needed to end a decade of economic stagnation. Only mid August when Italian bond yields shoot above 6.2%, Italian governement did come up with a big credible austerity program. But very rapidly austerity measures, one by one, have been watered down as Italian bond yields came down below 5% thanks to the ECB intervention. Therefore the ECB let the italian bond yields rise sharply. By doing so the central bank effectively forced the Italian government to make another U-turn yesterday by returning to most of the original plan.

Early this week in the Financial Times, German Finance Minister made a good summary of his thinking: short term pain for long term gain. (read the article http://www.ft.com/cms/s/0/97b826e2-d7ab-11e0-a06b-00144feabdc0.html#axzz1XGNvV9gr).

Stabilizing the financial system and the world economy is costly and nobody is really ready to pay the bill.

Public decision makers are left with only tough options. As far as the eurozone is concerned two options are really available: rewritten the rules of the eurozone or rewritten the rules of the banking framework. Then the question is quiet simple: is a direct recapitalization of the banking sector preferable to radically rewriting the rules of the euro zone through the creation of transnational euro bonds? German taxpayers might not be happy about recapitalizing their banks but we suspect that they would prefer that to permanently underwriting the spend and borrow habits of Athens or Rome.

As long as the eurozone is not well balanced (discipline in exchange of solidarity, sanctions in case of breach, incentives to be disciplined....) and growing on a sustainable path, lifting the core tier one ratio of european banks will do little.

Beyond the case of the eurozone a new economic framework focusing on job and business creations has to be defined and put in place. There is a consensus around that principle but a strong uncertainty around the details is prevailing.

What would be the cost for corporates?

The current equity market valuations are not just discounting a mild recession, they are also reflecting the fear that companies' free cash flow could be harmed to create more jobs in Europe. Governments may force or incentivise wisely companies to step up their investment effort. Modalities have to be defined but in the end the free cash flow will be under pressure.

Can a high double digit return on equity really coexist with a double digit rate of unemployment in a sustainable way? Record profits didn't save the equity markets throughout this cycle (relentless compression of the valuation mutiples). Sustainability will ultimately be rewarded even if it is costly in a first stage.

The rebirth of the equity market is no longer a question of valuation. Prospective PE ratios on major equity markets are low relative to the past 20 years but valuation average of the past 20 years may be questionable in a deleveraging world and more importantly equity market outlook is now slave to politics. In absence of a holistic policy response risk premiums will continue to climb and push global equities lower.

Equity markets have discounted the cost of the a new economic framework but they hate uncertainty. The guidelines and the shape of this new economic policy framework just need to be clarified and thus clear the horizon to push down the risk premium. The sooner, the better.

A liquidity crisis is making the headlines.​ Banks in the euro zone are for instance striving to finance themselves in dollars.

Paradoxically liquidity is plentiful, markets are awash with liquidity. But this liquidity is flock to safe havens (gold, swiss franc) and short term liquidity is only provided by central banks.

This is true that the funding is tricky nowadays but banks have plenty of access to short term euro liquidity, including from the ECB, and can use foreign exchange swaps to access dollars while they run down positions.

But the real challenge is the long term funding. Banks can't operate only with short term ECB's facilities.

This issue is going beyond the banking sector.

There is a deep crisis for long term financing in developed economies. The appetite to finance long term projects or invest into long duration assets is constrained or depressed to say the least. Too often people are making the confusion between duration and liquidity. A long term asset is not necessarily illiquid. For instance an equity portfolio can be sold very rapidly even if it is a long duration asset.

A good risk reward assessment and profitability considerations should drive capital allocations. That's no longer the case. People prefer to lose money with certainty in swiss T bills (read 3 September Liquidity trumps profitability) irrespective of the valuation of other asset classes.

Over the last decade financial engineering has fuelled too much the illusion of a potential liquidity.  A mismatch between assets and liabilities is always a recipe for a financial crisis.

It is now time to encourage risk taking in the long run. Long duration liabilities are required to allow investors to carry long term assets. Short term liquidity won't do the trick. So far regulation is heading in the opposite way by forcing banks to reduce their long term financing activities. Insurance companies are encouraged to hold as few equities as possible.

Everybody agrees that the Great deleveraging should be contained. No doubt about it but it does imply normal financial markets and an incentives for long term financing, long term investing. So far only central banks can counter act powerful deleveraging forces.

"In the long run we are all dead" said Keynes in 1923 (A tract on monetary reform). This is one of the most famous and well known prediction pronounced by an economist in the 20th century but people are not necessarily aware of the first part of the prediction which is "The long run is a misleading guide to current affairs". That's maybe not the case today. Having lost sight of the long run, the financial system is now in a such a bad shape. Time to encourage long term investing and financing.

Deleveraging if not contained is paving the way for a credit crunch and a destructive downward spiral for the real economy.

Deleveraging should be organized in an orderly way and last week we outlined the need to backstop the deleveraging (Fancy for the long run). Not everyone can deleverage at once.

The trouble is that recently the deleveraging is gathering pace with several major banks (BNPParibas, Societe Generale) forced to deliver at the same time.

Markets have no longer faith in banks with large balance sheets (more than 2000 billions € for BNPParibas and 1200 for Societe Generale) irrespective of their profitability.

French banks are critical in several financing businesses such as the global aircraft market through the provision of export credit and asset backed financing to airlines.

The new pending financial framework (Basel 3, Solvency 2) is putting too much emphasis on the safety and liquidity aspects and thus is jeopardizing the long term growth and the investment in real assets and jobs. While there was not enough focus on leverage and liquidity in the pre Lehman world the pendulum is now swinging back too much in the wrong direction.

An unlimited preference for liquidity is pushing the real economy to the edge. Nowadays liquidity trumps capital allocation decisions. In a normal world the risk-reward equation should guide decisions.

Equity investing has now become a by product of a credit analysis.

Last week I get a straightforward question "Should we look at the Europe future as the Japan 90-10 period?"

Rightly so the spectre of Japan is haunting Europe and the comparison has become highly fashionable.

Developed markets, and not simply Europe, are demonstrating many of the characteristics and processes that marked Japan's course after the bubble burst in 1989-1990.

Europe as Japan two decades ago is facing the challenges posed by a deleveraging cycle. Moreover Japan is the only developed market among 31 that have run up against the need for large scale fiscal adjustment programmes since the  early 1980s not to have subsequently stabilized or reversed its public debt burden.​

The biggest difference with Japan is the way the debt crisis can be solved and the time horizon. Japan has managed to quadruple it public debt to GDP ratio to almost 240% since 1990. It has been able to do this without turbulence thanks to its high stock of savings, its low reliance on foreigners to buy Japanese government bonds at depressed yields. There is also a political aspect. The Japanese story has been well flagged in terms of unwillingness to embrace economic and budgetary reform.

Europe is willing to act but is also facing a tougher situation as the institutional framework is very much different. Europe has to build a consensus, a cohesion among members having a different vision (the north-South Divide), the ECB is eager to keep its independence and thus reluctant to monetize the sovereign debt in scale.

Europe has started to react more strongly than Japan (pan european rescue fund EFSF) but several changes do require a long and cumbersome national parliamentary process or a new pan european treaty.

There is no fatality in the making. Whether or not we will all become Japanese will ultimately depend on policy action. A financial crisis is always protracted and as such requires an appropriate policy response.

China is becoming a hot topic again. It may become the next shoe to drop. It is simply amazing to see the number of gloomy papers I received over the last 48 hours.

Early July we outlined the long standing risk (read 6 July Welcome to a China's subprime?) of a rising informal lending market in China. In the meantime it has been totally overshadowed by the sovereign crisis in Europe. We hold the view that the shadow banking system is a time bomb but that Chinese authorities have the capacity to postpone the day of reckoning.

However the Chinese property market is going from bad to worse.

The bulk of the informal lending has been channeled into the property sector. The biggest borrowers are the small or medium sized real estate developers. The lending channel to developers is particularly worrying as most chinese developers have never experienced a bear market cycle. They usually refuse to cut prices in a time when transaction volumes have fallen sharply and pay interest rates ranging 14-70% on an annualized basis, hoping that the government's tightening policy will ease soon.

The property sector has been a focus and recent news of a regulatory investigation into Chinese developers' trust transactions is not helping. The credit risk is becoming apparent. The bond yield on some property developers is sky rocketing as shown below.

Source: Bloomberg, Bofa Merrill Lynch Global Research.

The shadow banking system has the potential to be disruptive for China. The market is starting to recognize it as testified by the sharp rise in China's sovereign CDS spreads. They have risen by 40bps over the last 10 days and the spread vs Bunds has widened by 40bos this month. 

Source: Exane

Given its underground nature, it is unclear when this time bomb may explode but something is likely to happen over the next 12 months. In any case investors will remain cautious until Beijing is taking pro active and decisive measures to deal with the issue.

​Some days ago Mr Wen, Chinese Premier, warned that China could be a helping hand for the euro zone but that it can't save the world. He even advised European countries to put their house in order. Maybe he should also not forget  to clean its own economy.