“The Buddha taught that you can only understand something by looking deeply at its interconnectedness to other things, and to our own selves – nothing has a separate existence. ‘This is, because that is; this is not, because that is not.’ The problems and imbalances that have inflamed the world did not emerge from a vacuum. Rather, this is, because that is.” (John Hussman)

1. My first point is that we are in a highly dangerous macroeconomic environment and that the long-term return prospects for most markets are low. The extraordinary monetary and budgetary measures have only provided a relatively mediocre economic recovery that is still very fragile. Broadly speaking, these measures are only the continuation of those that led to the crisis in the first place and are doing nothing to resolve the fundamental problems. More often than not, they have had counterproductive effects, with the Federal Reserve’s policy contributing to the hike in commodities prices and the fall in the dollar, which have resulted in a decline in US consumer purchasing power. The measures have also led to an unprecedented deterioration - in peace times at least - in the public finances of the industrialised countries. The upshot is that if another crisis was to emerge, the authorities would have practically no room for manoeuvre.

2. The economic stimulus measures have led to a strong advance in stock prices over the past two years and pushed the markets to levels that strongly impede their long-term return potential ('the price paid determines the return' is still the most important rule in investment). Arguing that you should buy stocks because interest rates are low and bonds are unattractive is stupid and does not hold water from an historical point of view.

3. In light of the above, our investment strategy will maintain a strong defensive bias (unless the markets slump, which would bring stocks down to much more attractive levels). Of course, we are aware that a new round of monetary easing in the United States could prolong the stock market rally of the past two years. It is our opinion, however, that participating in this rally involves a great deal of risk. Contrary to financial theory which equates risk with volatility, we believe that the main risk for an investor is the loss of his capital. In other words, a strategy that produces moderate gains in 80% of cases but huge losses in 20% of cases is not acceptable for us.

4. It is important to note that having a defensive strategy does not mean that we are avoiding stocks. The traditional distinction between equities as risk assets and bonds as no-risk assets no longer makes sense in the current climate where businesses are often in better financial shape than governments. There seems to be little long-term upside potential from current levels for the stock markets, but within markets, there are attractive pockets of opportunity. Our investment themes are still ‘quality companies in defensive sectors’, ‘dividends’ and ‘emerging markets’. In terms of fixed income, some of the emerging markets are also offering a much better risk/return trade-off than bonds in most of the industrialised world.

5. As far as the events in Japan and the Middle East are concerned, one thing seems clear – they are putting further upside pressure on oil prices, thus increasing the prospect of an energy crisis. In the industrialised world, soaring oil prices are a deflationary not an inflationary event. They reduce consumers’ buying power and exert downward pressure on profit margins. In the United States, real wages (adjusted for inflation) fell in five out of the six past months.

6. Rebuilding Japan’s destroyed infrastructure will require raw materials and in turn support prices of these raw materials. Once again, it is important to point out that unlike in the past when rising commodities prices were usually a consequence of the strength of economic activity in the industrialised countries (and had therefore an inflationary bias), today this increase is resulting from the strength of economic activity in the emerging markets and geopolitical factors, and has therefore a deflationary impact on the industrialised countries. The fears of contamination of the food supply chain does nothing to reduce the inflation in global agricultural prices.

7. The tragedy in Japan has happened at a time when the Japanese government is facing huge debt and where the savings (of its population) required to support this debt are diminishing as its population ages. There are fears that the Japanese authorities will in turn resort to large-scale quantitative monetary easing (a euphemism for printing money). With the confidence in the dollar largely undermined, the euro could remain the default currency despite the problems within the eurozone. In the longer term, this situation could result in a new monetary order in which the emerging creditor countries would accept to revalue their currencies as the price to pay for being able to conduct independent monetary policies. Current inflation trends in these countries, the result of rising commodities (especially food) prices, could accelerate this process.

8. The fact that many strategists are recommending using the correction in the wake of the events in Japan to buy stocks is quite revealing of a state of mind that believes that any slump in share prices is a buying opportunity. First of all, the correction is negligible in light of the rally of the past two years. Second, risks are plentiful given the events in Japan, Bahrain, Yemen and Libya, the debt crisis in Europe, monetary tightening in China, and the prospect of the end of QE2 (the second round of the Federal Reserve’s extraordinary monetary easing) in the United States (1). Many markets have doubled in value since March 2009 and it would be naïve to think that these risks are currently factored into prices.

9. The Japanese stock market itself is currently relatively cheap. Companies are trading on average at one time their book value, compared to other countries where this ratio is well above two. As well as this, Japanese companies’ return on equity, traditionally low, is starting to improve.  

10. In conclusion, the events in Japan and the (slight) correction in equity prices do not constitute a buying opportunity. In March 2009, stocks were trading at relatively attractive levels, and the economy and corporate earnings had begun to improve. Today, we are in the opposite situation. The rally of the past two years constitutes an opportunity to undertake a fundamental repositioning of investment portfolios, however, away from those countries whose fundamentals are deteriorating and towards those whose fundamentals are sound or improving.

(1) The end of the first round of extraordinary monetary easing in April 2010 led notably to a 12% correction in the S&P 500 and aroused fears of a return into recession. It was this situation that prompted the Federal Reserve chairman, Ben Bernanke, to hint at a new round of monetary easing as soon as the end of August. Today, some members of the Federal Reserve Open Market Committee are already talking about the need for QE3.