Microsoft word - cazenove european absolute return fund july 09.doc

Cazenove European Equity Absolute Return Fund The fund fell an estimated 0.9% (gross - internal estimate) over the month of June. Looking at the distribution of contributions to performance it is difficult to glean any pattern at all. After the rally comes the summer drift. The coming month will see US and European companies begin to report their second quarter earnings, but we see little chance the market will be given the crucial “signals” it needs. On average, we anticipate that Q2 earnings for financial companies should beat expectations, especially market-related banks, as QE weaves its magic spell on profits. Non-financial earnings are likely to disappoint, however. We have consistently made the point that non-industrial earnings have not yet fallen to the trough levels typical of previous cycles. To some extent this is a function of discipline on price, companies having sacrificed volume to protect margins. Admirable though this is, it runs the risk of destroying demand further in 2010 as disposable income weakens (more of this later). What is important is that neither reported earnings nor, we suspect, outlook statements will provide much of clue as to whether we have hit the bottom of the non- financial corporate earnings cycle. But with policy unlikely to change until the end of 2009 at the earliest, we see few reasons for the market to break its summer torpor which seems to have set in rather early this year. The rally, as far as we are concerned, does not yet represent a new bull phase. The reason for this assertion is that price action within the market remains stunted. The rally in banks and resources – the two sectors at the heart of the 2000 to 2007 bubble – is a classic move up in the two sectors with the highest short-term observed betas. Remember that in November of 2008 implied equity market volatility reached 90% and bond yields fell towards 2%. Now that equity volatility has fallen to 25% and bond yields have reached 3.5 to 4%, it is no surprise that resources and banks have performed so well. The rally in a way can be explained almost exclusively in terms of the move in the risk premium described above – there is little need to resort to “green shoots” to explain market action. We would argue that the failure (so far) of the market to broaden out in any meaningful way to other stocks and sectors is prima facie evidence that we cannot yet call this anything other than a prolonged bear market rally. As our investors are aware we believe our portfolio would benefit from a broadening out of market price action, away from the current narrow leadership, and towards growth, defensive, and consumer shares. That this is not yet happening is ultimately the factor behind the lack of upward momentum in the fund’s returns. This is not a passive stance. We believe it would be potentially disastrous to chase momentum for its own sake. Momentum is located in the expensive parts of the market. Our analysis indicates that growth and defensive shares are the best source Over the month of June, the fund averaged a net exposure of 24%, 19% on a beta-adjusted basis. This had come down below 20% by the end of the month as we put in place a small short position in the future in recognition of the strength of many asset markets over Q2. Gross investment averaged 161%. As volatility has dropped and our skew is now less aggressive, the 10-day 95% VaR fell below 3. As mentioned above attribution provides little clue as to the overall drawdown in June. Indeed our biggest contribution by far was a successful short in a potash producer which had its long-awaited (at least by us!) profits warning. This added 75bps to performance. Outside of this there is little or no pattern at all – our long positions just fell slightly more than short positions, with the net bias a small negative. Our long position in Sanofi fell at the end of the month over worries over the safety of key drug Lantus. We had actually sold 15% of our holding ahead of the announcement as the stock had been performing strongly so it only cost 9bps overall. We have used these notes to outline some of our longer term views so there is little need to revisit them in detail this month. We shall focus instead on two considerations: inflation vs deflation, and positioning the portfolio after the inventory bounce. We have been speaking to clients recently outlining our view as to why one cannot definitively say today if inflation or deflation will dominate the investment landscape in the Cazenove Capital Management Limited, 12 Moorgate, London EC2R 6DA. Telephone +44 (0)20 7155 5600. Registered Office 12 Moorgate London EC2R 6DA Registered in England No 3017060 Regulated by the Financial Services Authority Cazenove Capital Management Limited provides independent advice decade to come. We feel an inflationary outcome can only be achieved with wage inflation. There is scant evidence of this today, though it is not impossible. We view the probability of localized inflation (say, just asset prices, not in goods and services) almost non-existent. That was the trick of 1997 – 2007. The belief it can be repeated is, we suspect, just wishful thinking. Our main objection is simple. We started 2009 with an unprecedented level of stock of debt which requires servicing from cash flow. If QE gets asset prices back up to this nominal level of debt, then there would be a consequent rise in long term interest rates and fall in the external value of the currency. Thus the ability to service the debt from cash flow needs to rise in a proportional ratio to the rise in the asset price. QE and monetary expansion will only achieve inflation if it can be manipulated into the hands of workers though wages. No, the more likely source of long term inflationary pressure is more likely to come from fiscal profligacy. Western policy is likely to remain over-loose for some time, but we are increasingly leaning towards the view that the pressure on prices could be downwards over the coming years. The main factor behind this view is our sense that consumers and savers will gradually shift their behaviour patterns in response to the crisis of the last eighteen months. Westerners over-consume and under-save and the crisis has probably taught them that this imbalance cannot last. Therefore, no amount of fiscal profligacy will prevent a structural rise in the savings ratio, as individuals in the West disintermediate the policies of their governments and central banks by counter-balancing the rise in consumption (or dis-saving) by the State. So if savings rates rise and wages are not inflated, disinflation or very mild deflation is the more likely outcome. One outcome we believe has little chance of being realised is the non-inflationary growth of the last 25 years – funded as it was by rising levels of indebtedness. Thus the key call for most investors over the next 10 years will be equities versus bonds, not equity long-short But this will likely only begin to exert an influence over our portfolio construction in the years to come. We believe a more pressing opportunity may soon present itself. We are strongly of the opinion that the key drivers of personal disposable income will weaken as we enter 2010. Rising deficits of the scale we have seen will require rising tax rates as well as curbs on spending. The authorities’ ability to keep a lid on mortgage rates is likely to weaken into 2010 - and the oil price is no longer dropping. Thus demand will likely be weaker in 2010 compared to 2009. This means that our year-long over-weight position in consumer cyclical sectors, which we implemented as a natural consequence of our bearish view of commodity prices, is likely to be reversed as we move towards Christmas 2009. There is no rush as the second half offers good like-for-like comparisons and disposable income is basking in the sunshine of low mortgage rates and lower energy prices. The obvious business cycle style group to hold long against this potential short will undoubtedly be Growth, which harbours the sort of stock in which we are becoming increasingly interested – namely companies that can compound their earnings after the inventory-led bounce of 2009. The key thesis here is that the rise of deficits in the West will crowd out private sector activity and make the recovery anaemic relative to previous recoveries. Thus compound growth stocks must re-rate. Our job is to find them but they should form the lion’s share of our long book as we move into 2010. Cazenove Capital Management Limited, 12 Moorgate, London EC2R 6DA. Telephone +44 (0)20 7155 5600. Registered Office 12 Moorgate London EC2R 6DA Registered in England No 3017060 Regulated by the Financial Services Authority Cazenove Capital Management Limited provides independent advice Regulatory Information and Risk Warnings This document is issued by Cazenove Capital Management Limited (Cazenove Capital), a firm authorised and regulated by the Financial Services Authority. It is for information purposes only and does not constitute an offer to enter into any contract/agreement nor a solicitation to buy or sell any investment or to provide any services referred to therein. Cazenove Capital provides independent advice. This document is issued for communication only to persons to whom this document may, for the time being, be communicated by Cazenove Capital by virtue of the Act (Promotion of Collective Investment Schemes) (Exemptions) Order 2001, rule 3.11.2 and annex 5 of the FSA's COB Rules or any other exemption to section 238 of the Act. The contents of this document are based upon sources of information believed to be reliable, however, save to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to its accuracy or completeness and, Cazenove Capital, its directors, officers and employees do not accept any liability or responsibility in respect of the information or any recommendations expressed herein which, moreover, are subject to change without notice. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. They are unregulated collective investment schemes operated in offshore centres that are unlikely to offer a level of investor protection equivalent to the UK. Such schemes may deal infrequently and may limit redemptions. Past performance should not be seen as an indication of future performance. Values may fall as well as rise and you may not get back the amount you invested. Income from investments may fluctuate. Changes in rates of exchange may have an adverse effect on the value, price or income of investments. The levels and bases of, and relief from, taxation may change. You should obtain professional advice on taxation where appropriate before proceeding with any investment. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. Cazenove Capital Management Limited, 12 Moorgate, London EC2R 6DA. Telephone +44 (0)20 7155 5600. Registered Office 12 Moorgate London EC2R 6DA Registered in England No 3017060 Regulated by the Financial Services Authority Cazenove Capital Management Limited provides independent advice


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