Investors are shielded by their blind faith in China
Wednesday, 5 December 2007
David Bowers
AT a time when investors face the biggest credit squeeze in a generation, what is puzzling is how little the world's equity markets have been affected. As credit spreads blow out beyond August's levels, it is perplexing to see global equities a mere 8.0 per cent off their 2007 highs.
Fixed-income markets tell a very different story: junk bond spreads have widened to levels normally associated with a US recession; real yields on US inflation-protected securities have plunged more than 100 basis points in less than six months and Fed Fund futures are discounting another 75bp off US rates in 2008.
Yet the conventional wisdom among asset allocators is that stocks are fairly valued (and getting cheaper) and that bonds are overvalued (and getting more expensive). The markets still want to work off the template of 1998, when a containable financial event (Long Term Capital Management) forced the Fed to ease monetary policy. That, in turn, provided the liquidity that fuelled the tech bubble of 1999/2000.
We believe the resilience of equities in the face of the credit squeeze stems from a deep-seated belief in economic decoupling at three levels. First, investors hope the US "real" economy can yet decouple from the US "financial" economy, that Main Street can decouple from Wall Street. Second, even if the US economy does slip into recession, investors believe the rest of the global economy can decouple and grow strongly. Third, asset allocators take the view that equities can decouple from the credit turmoil because they are cheap, not just in absolute terms, but relative to other assets, such as bonds and real estate.
In our view, the consensus still fails to grasp the enormity of what is at stake, in essence a threat to the global credit creation mechanism. The process of "securitisation" is too big, too integral to fail. That may be true, but by the time this crisis is over, it is going to be a lot more tightly regulated - not least as procyclical Basel II capital adequacy rules are implemented. That could change the supply of credit. The big issue next year is not going to be the cost of credit; it is going to be the availability of credit. Companies face a shock as they realise they can no longer boost return on equity simply by issuing debt to buy back stock. They will have to learn to run themselves "for growth", and not just "for cash".
However, for a bear market to take hold, the problems of the financial sector are going to have to become the problems of the non-financial sector. One catalyst could be disillusionment with global emerging market equities in general, and with China in particular. In 1991 the turnaround in the US banks after three years of underperformance came only after the Japanese equity market bubble burst. In 2000, two years of underperformance by US banks ended with the bursting of the technology bubble.
This time the resilience of equities in the face of the credit squeeze may depend on the bull market in emerging market equities. Chinese infrastructure spending has become the talisman investors believe will ward off a more broad-based bear market. No surprise then that emerging market equities remain asset allocators' top pick.
The trouble is the asset class is looking exposed after this year's outperformance. Emerging market credit spreads have blown out in parallel with US high-yield and investment-grade spreads. Commodity prices - a key driver for the asset class - are showing mixed signals, with gold, oil and softs up, but base metals lower than a year ago. Corporate news flow in the "Bric" economies of Brazil, Russia, India and China shows sentiment is deteriorating. However, the asset class remains underpinned by inappropriately slack monetary policies exported from the US via fixed exchange rate pegs, a framework that carries the risk of inflation.
Equities have held up better than the macro fundamentals implied by the bond market because few investors yet have the courage or cause to bet against China and question the emerging market bull case. In our view they focus too much on the number of potential new consumers in the developing world and not enough on whether the monetary framework these countries are using is appropriate and sustainable.
(The writer is joint
managing director of Absolute Strategy Research)
— FT Syndication Service
AT a time when investors face the biggest credit squeeze in a generation, what is puzzling is how little the world's equity markets have been affected. As credit spreads blow out beyond August's levels, it is perplexing to see global equities a mere 8.0 per cent off their 2007 highs.
Fixed-income markets tell a very different story: junk bond spreads have widened to levels normally associated with a US recession; real yields on US inflation-protected securities have plunged more than 100 basis points in less than six months and Fed Fund futures are discounting another 75bp off US rates in 2008.
Yet the conventional wisdom among asset allocators is that stocks are fairly valued (and getting cheaper) and that bonds are overvalued (and getting more expensive). The markets still want to work off the template of 1998, when a containable financial event (Long Term Capital Management) forced the Fed to ease monetary policy. That, in turn, provided the liquidity that fuelled the tech bubble of 1999/2000.
We believe the resilience of equities in the face of the credit squeeze stems from a deep-seated belief in economic decoupling at three levels. First, investors hope the US "real" economy can yet decouple from the US "financial" economy, that Main Street can decouple from Wall Street. Second, even if the US economy does slip into recession, investors believe the rest of the global economy can decouple and grow strongly. Third, asset allocators take the view that equities can decouple from the credit turmoil because they are cheap, not just in absolute terms, but relative to other assets, such as bonds and real estate.
In our view, the consensus still fails to grasp the enormity of what is at stake, in essence a threat to the global credit creation mechanism. The process of "securitisation" is too big, too integral to fail. That may be true, but by the time this crisis is over, it is going to be a lot more tightly regulated - not least as procyclical Basel II capital adequacy rules are implemented. That could change the supply of credit. The big issue next year is not going to be the cost of credit; it is going to be the availability of credit. Companies face a shock as they realise they can no longer boost return on equity simply by issuing debt to buy back stock. They will have to learn to run themselves "for growth", and not just "for cash".
However, for a bear market to take hold, the problems of the financial sector are going to have to become the problems of the non-financial sector. One catalyst could be disillusionment with global emerging market equities in general, and with China in particular. In 1991 the turnaround in the US banks after three years of underperformance came only after the Japanese equity market bubble burst. In 2000, two years of underperformance by US banks ended with the bursting of the technology bubble.
This time the resilience of equities in the face of the credit squeeze may depend on the bull market in emerging market equities. Chinese infrastructure spending has become the talisman investors believe will ward off a more broad-based bear market. No surprise then that emerging market equities remain asset allocators' top pick.
The trouble is the asset class is looking exposed after this year's outperformance. Emerging market credit spreads have blown out in parallel with US high-yield and investment-grade spreads. Commodity prices - a key driver for the asset class - are showing mixed signals, with gold, oil and softs up, but base metals lower than a year ago. Corporate news flow in the "Bric" economies of Brazil, Russia, India and China shows sentiment is deteriorating. However, the asset class remains underpinned by inappropriately slack monetary policies exported from the US via fixed exchange rate pegs, a framework that carries the risk of inflation.
Equities have held up better than the macro fundamentals implied by the bond market because few investors yet have the courage or cause to bet against China and question the emerging market bull case. In our view they focus too much on the number of potential new consumers in the developing world and not enough on whether the monetary framework these countries are using is appropriate and sustainable.
(The writer is joint
managing director of Absolute Strategy Research)
— FT Syndication Service