Investment Theme du Jour
Equity markets have decoupled from debt markets, emerging markets from developed markets and the U.S. dollar from just about everything.
Investment Theme du Jour
Market volatility creates investment uncertainty. Unfortunately, investors do not like to sit too long on the sidelines. As Will Rogers observed: "You've got to go out on a limb sometimes because that's where the fruit is."
The investment theme du jour is "decoupling" - equity markets have decoupled from debt markets, emerging markets have decoupled from developed markets and the U.S. dollar has decoupled from just about everything.
Short-term government securities have acted as a safe haven for money in transit. Interest rate traders have bet that the U.S. yield curve will steepen as the Fed cuts short terms rates and the long end reflect fears of inflation. European interest rate may follows as economies weaken responding to a U.S. slowdown and a stronger euro.
Debt is distinctly out of favor. The problems of structured credit, secularizations, Collateralised Debt Obligations ("CDOs"), Structured Investment Vehicles ("SIVs") and ABS conduits are well documented. Lack of transparency, poor liquidity and concern about the meaning and validity of credit ratings has led investor to switch to other assets.
Debt is also less attractive in an environment of increasing inflation. Fundamental price pressures are coming from higher energy costs, increasing food prices and rising inflation in emerging markets. The price pressures are exacerbated by seemingly deliberate policies from central banks to inflate their way out of the credit crunch.
Investments reliant upon abundant and cheap debt - highly leveraged hedge funds, private equity, infrastructure and property look less attractive.
Equity markets have benefited from lower interest rates, strong corporate balance sheets and profitability. The perception that equity is more transparent than structured debt and offers liquidity has increased its attractiveness.
Demand for stocks is uneven. Financial institutions (facing ongoing losses from further writedowns and uncertain future profitability), housing and construction related stocks (slower housing demand and commercial real estate activity) and cyclical stocks (dependent on economic growth) are out of favor. Fear of inflation underpins demand for real businesses with strong, preferably recession insulated cash flows. Fossil energy, hard commodities and food producers are key areas of focus. Alternative energy, water resources, essential infrastructure (especially in emerging markets) and environmental services are perceived as attractive.
Support for equity markets has an emerging markets angle. Emerging market growth is expected to be insulated from the turmoil of developed markets. Suppliers to emerging markets ( e.g. commodity producers) are seen to be protected from a US and European downturn.
Outward investment flows from China, India, Russia and the Middle East - the emerging market "bid" - are a key driver of equity market resilience. Sovereign investment funds or firms closely allied to the State increasingly prefer equities and real businesses to traditional purchases of high-grade debt. The motivations are strategic as well as financial – primarily, secure access to resources, international brands and distribution channels for products and acquiring skills essential to domestic growth.
Examples include: Industrial and Commercial Bank of China's (ICBC") purchase of a 20% stake in South Africa's Standard Bank, China Development Bank's ("CDB") investment in Barclay's Bank (BCS), China Construction Bank's ("CCB") purchase of Bank of America's (BAC) Asian operations and Bank of China's ("BOC") purchase of Singapore Aircraft Leasing Enterprise ("SALE"), Asia's largest aircraft operating lessor. Chinese banks are thought to be interested in Standard Chartered Bank. Indian examples include Tata's purchase of Tetley Tea and Corus. Tata as well as other Indian car-makers are bidding for Jaguar and Land Rover. Mubadala Development, an investment firm controlled by Abu Dhabi, recently purchased 8.1% of Advanced Micro Devices (AMD). Chinese and Indian firms have been also active in purchasing resources businesses in Africa.
Marquee assets fallen on hard times have attracted distressed asset bids. In 1991, Saudi Prince Alwaleed bin Talal invested US$ 600 million in convertible shares paying a dividend of 11% to help rescue Citicorp (C), crippled by commercial real estate and Latin American loan losses. In a case of "déjà vu all over again", the Abu Dhabi Investment Authority invested $7.5 billion in November 2007 in convertible stock yielding 11% to recapitalize Citigroup, threatened by losses on sub-prime real estate and private equity loans. Citigroup also took a significant equity stake in investment bank Bear Stearns (BSC) also suffering from losses on its sub-prime mortgage business.
To date, banks and sovereign investment funds have invested around a staggering $40 billion in Western financial institutions in recent months.
A weak U.S. economy and concern that the Fed will continue to ease interest rates in an attempt to prevent recession and support the banking system weighs heavily on the dollar.
Major dollar investors, especially Asian central banks who have invested a substantial portion of their reserves in U.S. dollar assets (estimated around 60-70%), have started to diversify their currency investments. Moves to replace the dollar with the Euro as the settlement currency for trade in key commodities such as oil, if it eventuates, also removes an underlying pillar of support.
This has supported currencies, especially emerging market currencies or currencies seen to be closely linked to these markets. Appreciating currency values reinforce asset values in these markets triggering positive feedback loops. This helps keep the emerging market asset price bubbles going.
The risks of the new investment orthodoxy are high and largely ignored. But as Keynes observed:
"It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees ."
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