This does not seem to be the best attitude to quell other countries’ potential desire for independence. Rather, the focus should be on structural change, higher growth policies and closing the gap between the elite and the people. With German and French elections scheduled for 2017, the window for action is short – and the EU unfortunately not renowned for its speed of decision (read more).

During this highly uncertain period, odds are that central banks will once again play saviour. Zero (even negative in some cases) interest rates policies will thus persist for longer than anticipated, perhaps to the point of undermining the value of paper money (read more).

In turn, this makes investors ever more desperate for yield, prepared to accept corporate bond yields that on average no longer cover default rates and to take significant valuation risk on equities in order to receive a dividend yield of just 2-3%. At some point, when investors realize the dea(r)th of opportunities, their search for yield is likely to turn into a run for capital protection. Should such protection not be readily and sufficiently available, things could then take a very ugly turn. If a large number decide to instead spend the cash injected by central banks over the past years, the velocity of money would rapidly rise and inflation shoot up.

But that crossroad has yet to be reached. For now, while increasingly wary of bonds, we still see yield opportunity in emerging market debt: sovereign paper or bonds issued by supranational institutions. This asset class has underperformed markedly for the past couple of years, hurting the many investors that piled into it up to early 2013. Cutting exposure to the European high yield bond segment – which no longer really warrants that name – and switching the proceeds into emerging market debt currently seems a judicious move (read more).

The equity portion of our portfolios remains invested mainly in strong companies that operate in difficult business environments, thus trade at a discount. As stressed in prior letters, given the rich multiples of broad equity indices, we prefer business risk over valuation risk.

That said, we do opportunistically take index exposure – recognizing that every correction is met by further central bank liquidity injections. As such, having (for the sake of prudence) sold our European equity index position ahead of the UK vote, we bought it back during the ensuing correction.

Finally, we continue to hold various hedges, notably gold and a volatility fund – which are fortunately functioning better this year than last. In placing capital protection ahead of yield, we would like to believe that we are one step ahead of the investment crowd.


The precise economic consequences of Brexit are extremely difficult to predict – an exercise from which we prefer to abstain at this stage. Suffice to say that the two or more years during which the UK will still be part of the EU should provide time to negotiate exit terms that work reasonably for both parties.

Politically, the fact that no one was truly prepared for a leave vote, witness the disarray in leadership that has since occurred across the UK party spectrum as well as EU leaders’ scramble to make a statement, is astounding. In a sense, it proves our case – discussed at length in last month’s edition – of a growing disconnect between the middle class and the political elite. Thus far, policymakers have preferred to ignore worker/voter discontent and the signs of pending societal change. With Brexit, that is no longer an option. If EU leaders want to prevent a domino effect, they need to act.

The question is how to move the EU forward, and keep it together. Two opposite routes are possible. One involves more integration, the other less. Intellectually, the elite probably favours the first. During the EU’s 70-year history, crises have often been the trigger for institutional reform; it is in periods of turbulence that the European project has progressed. Should this then not be the time to implement the fiscal transfers that have so been lacking since the adoption of the euro in 1999? Practically of course, this would mean the strongest economy in the region, Germany, having to foot much of the stimulus bill – by no means an evident prospect.

The second route would give member countries greater leeway, notably to run the budget deficits that they deem fit – that respond best to their own economic circumstances. The union would revolve around the (few) issues that all countries, or should we say the people of all countries, can agree upon, e.g. free trade and defence policies.

Time is another concern. General elections in Germany and France are scheduled for 2017, shortening the window for reform. Given the notably slow EU decision-making mechanism, and widely divergent starting positions between the core and the periphery of Europe (indeed also within the core), it is not obvious that significant institutional changes can be effected in such a brief timeframe. And even if it were to be the case, the resulting stimulus measures would probably not have time to deploy their effects before Angela Merkel and François Hollande’s terms end.

From a longer term perspective, we should also point out that while current budget deficit levels may well allow for some fiscal stimulus measures during the next quarters, be it at a country or the EU level, the problem of excessive public debt remains acute – ultimately limiting what can be done to boost European growth.


Under the Bretton Woods system, holders of paper money had the certainty of being able to exchange it against gold, a real asset. When this so-called “modified gold standard” was abandoned in 1971, high quality government bonds effectively replaced gold as the “no capital risk” asset into which physical cash could be always swapped.

But massive quantitative easing programs implemented by central banks during recent years in response to the global financial crisis have undermined this.

Quantitative easing involves central banks “printing” money to purchase financial assets, in the hope that the liquidity thereby injected into the system will stimulate economic growth and alleviate deflationary fears. In the process, it simultaneously drives up the stock of “paper” money and reduces that of government bonds available for purchase. A huge amount of these bonds are stowed away (forever?) on central bank balance sheets.

Beyond the disappointing fact that most of the liquidity injected by central banks has stayed within the financial sphere, fuelling asset price – rather than goods and services – inflation, the issue today is that holders of paper money can no longer be certain that it is exchangeable against “safe” government bonds and that their money will be returned in full at the maturity date of these bonds. Negative yields on government bonds in a number of countries, the most extreme cases obviously being Switzerland, Japan and Germany, are the very proof of that.

Unsurprisingly then, investors have been shifting to riskier bonds – accepting to put their capital at risk in order to generate some return. This quest for yield has resulted in a tightening of corporate spreads, all the way up the risk spectrum. Overall corporate bond yields may still appear positive but we would argue that, when adjusted for default rates, many are in fact now also close to or already in negative territory.

And default is not just a theoretical risk: recent bankruptcies in the US energy sector are a reminder that, notwithstanding supportive central bank policies, companies can and do fail – and that corporate bonds thus bear capital risk.


Corporate debt quality is deteriorating and this has to do with how companies have been allocating the proceeds of bond issuance. In many cases, rather than investing them into business development, they have used them to buy back stock – which of course has the short-term benefit of boosting earnings on a per share basis and supporting the share price.

From a longer-term perspective, however, issuing debt to buy back stock implies that the company’s debt ratios worsen and that its underlying business, to which no additional growth prospects have been provided, has to finance ever larger interest payments and redemptions. In our view, debt rating agencies have been slow to react to this worrisome pattern.

Given low to negative government and default-adjusted corporate bond yields, where can investors turn to for some return? We would argue that emerging market debt offers one of the last currently available opportunities. Emerging market bonds attracted massive investor interest through to the earlier part of 2013, before the Fed guided to a reduction of its monthly asset purchases, causing widespread “taper tantrum” in financial markets. The following years proved difficult for emerging economies, faced with an adverse mix of slowing growth and rising inflation. Energy producers saw their woes deepened by the decline in oil prices between mid 2014 and early 2016. Emerging central banks were forced to tighten monetary policy to address building price pressures and defend depreciating currencies. Emerging markets – equities and bonds alike – underperformed markedly, making them extremely unpopular.
With inflation now under control, oil prices recovering and China apparently not set for a hard landing, we feel that the time has come to reconsider investing in emerging market debt – an asset class that we exited early 2013, at the peak of its popularity. Local currency emerging market sovereign bonds offer yields in the vicinity of 6.5%, with the additional potential for currency appreciation from presently undervalued levels. Hard currency denominated bonds yield a slightly lesser 5.5%, still attractive relative to developed market peers and without exchange rate risk.

Once this emerging market debt opportunity has been exploited, we frankly feel that the chase for yield will be close to its end. Investors will eventually have to accept that aiming for high single digit portfolio returns is unrealistic, and focus instead on capital protection. Real assets such as gold should generate increasing interest – interestingly we note that a number of savvy investors are already building positions.