Edouard Carmignac: «Valuations are high in most markets and don’t reflect the buildup of risk in the world economy.»
Edouard Carmignac is worried. The founder of Paris based asset manager Carmignac says that China’s slowdown is a «time bomb» for financial markets and that investors are complacent: «Quantitative easing is not working anymore», he warns in an in-depth interview. «Central banks have reached the end of the road», says Carmignac. The risk of a large correction in equity markets is high.
Mr Carmignac, at the beginning of 2016 your analysts wrote that this will be the year where markets are beginning to awaken to economic reality: A slowdown in the US, Europe and China. What do you make of the macro environment today?
Let’s begin with China. The Chinese have pushed the pedal again to support economic activity, but they are not doing it in a virtuous manner.
They are just pushing their old model of infrastructure investment again. They are not addressing the issues they should be addressing. China has seen a very sizeable increase in lending again, monetary aggregates at large have risen further. This should increase pressure on the currency. At the same time, capital is leaving China. The People’s Bank of China is masking the drawdown in its currency reserves by acting heavily in the swap markets, but this won’t stop the outflow. For the time being, because of the actions from Beijing, financial markets have come to the conclusion that China’s slowdown is not a big issue anymore. True, it is not right now. But I believe this recovery of growth in China is not sustainable.
When will it show signs of a slowdown again?
I don’t know. There has been a recovery in inventory buildup, plus the money coming from the government in the past weeks. So we should see rather good growth numbers in the beginning of April. But inevitably, the forces of gravity will hold on and we will see a continuation of the slowdown in China.
When will financial markets start to be more concerned about that again?
When investors realize that capital outflows out of China are continuing at the speed we saw in late 2015. China is a time bomb for world financial markets.
How about the rest of the world?
The most important topic is this: Quantitative easing in Europe and Japan is going ahead at full speed, but markets are waking up to the fact that QE is not working anymore. The best example of this came from Japan: When the Bank of Japan introduced negative interest rates in late January, stock markets dropped and the Yen strengthened. We are starting to see it in Europe, too. The Euro has been strengthening lately.
And what about the US?
Janet Yellen, the head of the Fed, said in her most recent speech that she is not quite comfortable with growth and inflation numbers in the US. She clearly is worried about the strength of the US economy. For the time being, markets expect at least one more tightening step by the Fed this year, but I doubt that.
You don’t expect any further tightening by the Fed this year?
No. I don’t think Yellen wants to tighten further.
Over the past seven years, central bank policies were any investor’s best friend: They pushed all markets up. Are you saying that this time is over now?
The issue is that QE in itself does not work. It just works a little bit, if there is economic growth elsewhere. In Europe, QE can only function if the economic engines in the US and in Emerging Market work. If we don’t have that, we are in trouble. The only major economy that currently manages to sustain its growth is India, but India is a small player in global terms. So yes, markets are realizing that QE in itself has decreasing effectiveness. Don’t forget: The slowdown of the US economy and the weakening of the Dollar creates a problem for Europe, because Europe’s economy has mainly been recovering on the back of a weaker Euro. So we do see a similar development like in Japan, with the Euro appreciating instead of depreciating, even though the ECB is increasing its QE. So, central banks have used pretty much all their ammunition. Now the ECB even starts to pay banks if they lend. These are desperate measures.
A little more than three years ago, you told me that we should thank God for Ben Bernanke and Mario Draghi, because they stabilized financial markets. Your current view on central banks does not sound that generous anymore.
No, I’m not saying they have done something wrong per se. They have done what they could. But the ECB can’t foster real growth in Europe, they can’t force France and other European countries to reform themselves. Central Banks can’t foster sustainable growth in China. We have all these burdens on the world economy, which are still there, and central banks can do nothing about them. They have reached the end of the road.
What does that mean for markets?
The problem is that against this macro picture, we have valuation levels that are very very high. Prices in the bond market are just ridiculous, with negative yields in Europe, and now central banks are starting to buy corporate bonds as well.
Is that a bubble in bond markets?
Absolutely, that is a bubble.
And in equities?
Valuations are high in most markets and don’t reflect the buildup of risk in the world economy. Look at the S&P 500 in the US, where aggregated earnings this year are expected to be 120 USD per share, suggesting a P/E of 16. But this is on the basis of pro forma earnings, which are stripped of any unpleasant items. On the basis of gaap earnings, which are the only real earnings, the expectation is at 100 USD, which means a P/E of more than 20 for the S&P. That’s expensive.
With that view, does that mean that the relief rally we have seen since mid February will not hold?
No. It’s the same process that we saw in the fourth quarter of last year: In August, China created some anxiety, which caused a selloff. But then, people forgot about China and we had a rally starting in October. Then, in early January, China fears were spreading again and we had a selloff, followed by markets forgetting about China and a relief rally. It will not hold.
When will markets turn down again?
I don’t know. But for the time being, the equity risk exposure in our funds is very low. And within the equity allocation, we have a large overweight in defensive stocks in the healthcare and IT sectors.
Did you not use the market selloff in January to buy stocks on the cheap?
Yes, we did, but only among a few oil stocks, because we hold the view that oil price below 30 USD was not sustainable. Also, we took a position in gold mining stocks in late 2015, which have performed very well.
Are you not worried about valuations in the healthcare and IT sectors?
I sure would not say they are cheap. But in view of the strength of their franchise and their growth potential, I find their stocks are attractive. Take the three Knights of the Apocalypse for example, Google, Amazon and Facebook: They are virtually destroying all the companies around them that have thought they had secured themselves a niche in the internet. You just have to own those three, because they are the ones left standing.
A big position in your funds is Novartis, currently the only Swiss position. Novartis is down 30% over the past six months.
Yes, the share performance has been frustrating lately. Novartis is suffering from a number of factors. First, we are in an election year in the US, so drug prices have become an issue, which has affected all pharma stocks. Secondly, it has a major product coming out of patent this year, so there is no growth momentum to revenues in 2016, but next year we see a pickup again. Thirdly, they have this very effective heart drug, but it is a little too expensive, so market pickup of that drug is slower than expected. And lastly, there is a conglomerate discount on Novartis. We are becoming more and more concerned that the governance of Novartis is not as shareholder friendly as it should be.
Would you like to see them selling more business lines?
For one, the partial ownership of Roche is not creating any value. Either they should merge, or they should sell the shares and buy something better with the proceeds or pay the money out to their shareholders. Secondly, they made a very expensive acquisition of Alcon, which was improperly managed. And they have this generic business as well. So with Novartis, you are not buying a pure play drug company, and that warrants a discount.
What will turn the share price of Novartis around?
For one, I think the entire healthcare sector has been unduly punished lately. Secondly, we see an earnings pickup for Novartis in 2017, and we still like the long term story. But frankly, I think that some shareholder activists might target Novartis in the not so distant future and shake up the management. They need to improve shareholder returns. So at some point, this will happen, and in the meantime, the dividend yield is an attractive 4%.
You closed the entire position in LafargeHolcim in late 2015. Why?
We made a mistake when we bought the company. On the face of it, the merger made sense. Holcim had an excellent management, Lafarge not so much. So we thought that the merged company would take over the management ethics of Holcim. More importantly, we saw a lot of synergy potential in this capital intensive industry. So we thought they would be able to run their existing production capacity worldwide in a much more efficient manner.
And why did that story not play out?
For one, we adopted a much more cautious macro view. Secondly, we had underestimated the overcapacity issues in the global cement market. These issues were not solved by the merger, as other companies took over that capacity. So we found ourselves with a cyclical company, with a lot of debt on the balance sheet, in a challenging macro environment. That’s why we sold. There will be a time to buy LafargeHolcim again, but the overcapacity issues will have to be solved first.
Your flagship Investissement equity fund does not hold one share of any European bank. Why?
We made a lot of money with banks in 2014, but banks in developed markets suffer from a broken business model. They are selling a zero, if not negative return commodity. Secondly, as growth slows, the lending business is challenged further. Furthermore, banks are being challenged by alternative lending platforms, by technologies like Blockchain – they are being attacked all over the place. So all in all, it’s a very tricky time to be a bank in Europe. We do like banks in emerging markets, because interest rates are not negative there.
So even at 0,5 times book, you don’t see value in them?
You do own many bank bonds though in your funds. Is that the better investment?
Yes, for the time being. But I’m not sure how long we will be holding those bonds. There is no urgency in selling them, but if a company has a challenged equity, ultimately it will have a challenged debt as well.
You used to have a big position in Richemont. Not anymore. When will Richemont become interesting again?
First of all, Richemont is probably the best managed luxury company of the world. I have great respect for them. Richemont is a great call on the growth of disposable income in the middle classes of China and other emerging markets. It’s just that I see many more challenges in China in the near future. I could well imagine that China will introduce capital controls, thereby limiting Chinese tourists to go shopping outside China. Plus, the anticorruption campaign has been going on for three years, which continues to hurt sales of luxury goods in the country.
You are at your core a value investor…
…no, I rather like to buy companies that grow – but only at the right price. Risk-reward is my foremost investment principle, judging my risk of loss versus the potential upside.
Looking at the world today, is there any value at reasonable risk left?
On the stocks we own, yes. Our healthcare stocks or Google, Amazon and Facebook, for example. Also, I continue to like India, banks in India are very attractive. Brazil is interesting, valuation there has become very compelling, so we monitor closely how things evolve in Brazil. Some oil stocks are outright cheap, we would be buyers on further weakness in that sector. And we’re very fond of gold mining stocks.
You have advocated gold and gold mining stocks for many years. Have we seen a decisive turn in prices there?
First of all, the carrying cost for gold is negative today. In a world of negative interest rates, holding gold costs you nothing, apart from keeping a safe in your bank. Holding money on the other hand is becoming expensive. Gold is a good hedge against all kinds of accidents that are waiting to happen in the world financial system. And of course, ultimately, it is your hedge against inflation. There will be inflation in the long term, because we don’t succeed in growing our way out our debt. I think gold should at least be 5% in any portfolio right now.
But for the time being, the world seems to be stuck in a deflationary environment. Does gold really protect me from that?
You are right, there is deflation today. But deflation primarily hurts gold when interest rates are positive. With that not being the case anymore, the opportunity costs for holding gold are gone. You have to find a store of value that protects against all kinds of tail risks. Gold offers that. And rest assured: Central banks will do everything to combat deflation. They are running our of government bonds to buy, which means they are moving into corporate bonds. But ultimately, governments will just issue more debt that central banks will buy directly – and ultimately, that will create inflation. We just don’t know when.
What is your biggest worry?
A derailing of China.
And how worried are you about the state of France?
Well, thank God this pathetic interlude of a government is coming to and end soon. We have some very good candidates for next year’s election. An entire football team of candidates, eleven all in all.
Who would you like to see win?
I have my favourite, but I won’t tell you. Suffice to say that we need a change of generation and that we should not elect someone who has failed in his job before. France need a brush of fresh air.