Market volatility creates investment uncertainty. If economics is “the social science of choice under scarcity”, then investment currently is “the process of uncertain choices under abundance.” Investors, awash with liquidity, cannot 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 US dollar has decoupled from just about everything.
Short-term government securities have acted a safe haven for money in transit. Interest rate traders have bet that the US yield curve will steepen as the Fed cuts short terms rates and the long end reflect fears of inflation. European interest rate may follow as economies weaken responding to a US slowdown and a stronger Euro.
Debt is distinctly out of favour. The problems of structured credit, securitisations, 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. Companies with short-term debt that will need to be refinanced look especially vulnerable.
Alternative Equity …
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 favour. Fears 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.
“Alternatives” are attractive - energy, water resources, essential infrastructure (especially in emerging markets) and environmental services. Adding “alternative” to the business plan is fashionable just as adding an Internet angle was essential at the height of the dot.com era.
Support for equity markets has an emerging markets bias. There is both an “inbound” and “outbound” angle.
Emerging market growth is seen as 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. This has led to diversion of funds into emerging market equities and stock that benefit directly or indirectly from emerging market growth e.g. commodity producers.
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 purchase of a 20% stake in South Africa’s Standard Bank, China Development Bank’s investment in Barclays Bank, China Construction Bank’s purchase of Bank of America’s Asian operations and Bank of China’s 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 carmakers 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, 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 US$ 7.5 billion in November 2007 in convertible stock yielding 11% pa to recapitalise Citigroup, threatened by losses on sub-prime real estate and private equity loans. The Government of Singapore Investment Corporation ("GSIC") together with an unnamed Middle Eastern investors have taken a 10.5% stake in UBS of Switzerland for Swiss Franc 13 billion. Confusingly, Temasek, another arm on the Singapore Government, perhaps in a case of sibling rivalry, also took a US$4.4 billion stake in Merrill Lynch (a stake of less than 10%). Citic also took a significant equity stake (US$1 billion) in investment bank Bear Stearns also suffering from losses on its sub-prime mortgage business.
To date, emerging market banks and sovereign investment funds have invested a staggering US$40+ billion in Western financial institutions in recent months.
No Visible Means of Support…
A weak US 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 US 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. In Saudi Arabia even clerics have warned the ruling government to take action to curb rising inflation, blaming Riyadh's pegging of the Riyal to the US dollar.
The weakness of the US dollar 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.
In the “de-coupling” orthodoxy, equity is the new debt; emerging markets are “safe havens”. De-coupling assumes strong corporate earnings and healthy balance sheets. The credit crunch is a “financial” crisis that does not imperil the “real” economy.
Investors are going for “mo” - momentum. They are relying on Will Roger’s advice: “don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” There are reasons to be skeptical about the new investment mantra.
In developed economies, the financial sector is a large portion of the equity market. In the USA, the financial sector accounts for around 20% of the market value of the S&P 500 and around 30% of the index’s 2006 combined earnings. In Great Britain, the financial sector makes up around 10% of GDP and contributed around 30% of overall GDP growth in recent years. Financial institution profits are unlikely to achieve the stellar heights of recent years for a while. Analyst forecasts for a quick recovery in investment banking profits are optimistic. Recent sources of strong earnings – securitisation, structured credit, leveraged finance – remain moribund. Strong trading revenues (a result of high volatility), strong mergers and acquisitions fees and emerging market activity will need to remain at high levels to keep earnings respectable.
The US real estate sector – a substantial portion of the equity market directly and indirectly – faces difficulties. Residential housing markets in other countries – Great Britain, Ireland and Spain – look vulnerable. Commercial real estate is now being affected by the credit problems and the profit outlook is unclear.
Non-financial corporation profits, for example, American companies, have remained buoyant. Corporate profits as a share of economic output in the US in 2006 were at a record 40%. National accounts data from the US Bureau of Economic Analysis suggests that profit growth is slower. A similar gap between the reported and national account figures was evident in the late 1990s due to creative accounting.
Earnings growth has slowed in recent times. Slower growth in the global economy will further affect earnings. Borrowing against the increased value of property and financial assets has fuelled US consumption in recent years. Falling real estate values will affect consumer spending. The "consumer discretionary" sector (carmakers, consumer durables, retailers) faces a less promising earnings outlooks.
The "financialisation" of earnings and balance sheets of non-financial institutions is underestimated. General Electric's financial services earnings are 1/3 of total pre-tax earnings. Financial services are now a significant source of earnings for companies from different industries and countries; e.g. Ford, General Motors, John Deere, Caterpillar, Pitney Bowes, Sony, Honda. A major component is vendor financing to help increase sales. Financial earnings are vulnerable to higher defaults and also higher costs of funding.
For example, Porsche, the German car manufacturer, increased pre-tax earning by around Euro 3.7 billion (from Euro 2,110 in 2005/2006 to Euro 5,857 in 2006/2007). Earnings from equity derivatives (reputedly related to Porsche’s holding in another German carmaker Volkswagen) of Euro 3,593 million helped boost earnings. There are few details available on these derivative transactions. Porsche also benefited from a revaluation of its shareholding in Volkswagen of around Euro 700 million. During the same period, core earnings from Porsche’s car business were down by around 30% accordingly to equity analysts.
Andrew Smithers (writing in the Financial Times) used National Accounts data to question whether corporate balance sheets are really “in good shape”. He identified increased use of mark-to-market accounting, a rise in financial, non-tangible assets and increased leverage (including off-balance sheet borrowings) as major factors distorting reported financial performance. The problems are likely to become evident when asset prices fall.
There is also the financialisation of equity markets – share buybacks (many companies have been paying out more than their earnings in dividends and share repurchases), mergers and acquisitions and private equity bids. This depends on the availability of low cost debt. Private equity activity has slowed as funding becomes less available and more expensive.
As the oxygen of cheap and abundant debt is withdrawn a key pillar of support for the equity market will disappear.
Trompe L’oeil Markets
Emerging market equities, especially the Shanghai and Mumbai markets, have decoupled. Bizarrely, they “de-couple” only if the US markets fall but “re-couple” if the US market goes up!
Increases are driven by substantial short-term capital flows fleeing developed markets and the US dollar. The assumption is that valuations and earning growth are sustainable. Some prices in India and China are reminiscent of the surreal valuations of the dot.com and (earlier) Japanese equity bubbles. The quality and performance of recent initial public offerings have been variable and (in some cases) poor.
Earnings quality is variable and sometimes questionable. Earnings growth has increasingly been driven by investment income – stock market and property speculation. In a strong market, this accentuates earnings as higher investment earnings feed increasing share prices in a virtuous cycle. In a falling market, this works in reverse accelerating losses.
Returns on capital investment are variable. Chinese state funded businesses with access to cheap funds are not earning investment returns anywhere near the cost of capital. Many projects are predicated on high, continued economic growth well into the future.
The Indian and Chinese stockmarkets are trompe-l’oeils - paintings designed to deceive the eye. They provide a dangerous illusion of a modern economy for foreign investors. Electronic trading, complex financial instruments and (at least in the case of China) gleaming glass and steel structures mask deep structural problems.
The markets are far from being free and transparent. There is a nagging suspicion that prices are prone to being influenced by insiders and their associates. In the case of China, most traded shares are in government enterprises that continue to be controlled by the State. Chinese shares aren’t even really shares as they don’t convey full ownership rights equally to all shareholders.
The Indian and Chinese markets have been driven by a number of initial public offerings generously priced to provide investors (themselves privileged insiders) with large gains. A few shares contribute disproportionately to market performance. The rise in India’s Sensex Index in late 2007 was driven by few stocks. This reflects the lack of liquidity in many stocks. In China, restrictions on foreign investments by domestic investors and the lack of investment alternatives has contributed to the sharp increase in the price of Chinese stocks. Borrowings by corporations and individual investors have been channeled into the stock market creating dangerous levels of leveraged exposure to share prices.
Both markets fall a long way short of true financial markets designed to channel savings to productive investments.
Decouplings and Recouplings
De-coupling assumes that emerging markets will not be significantly affected by a US slowdown. Emerging markets fortunes generally are tied to the vagaries of globalised trade. Exports account for one-third of Chinese economic growth and 10% of GDP. India is dependent on export growth. Russian and Brazilian growth depends on commodity demand and high commodity prices. 80% of Asian intra-regional trade is driven by demand for outside Asia. A slowdown in the USA and Europe will affect growth.
Europe has the added problem of a weak US dollar. EADS (Airbus’ parent) recently complained that the strong Euro placed the firm’s viability in question - the plane maker's chief executive used the phrase “life-threatening”.
Belief that domestic consumption can take over from exports as the growth engine in emerging markets is untested. Any Xie (a former Morgan Stanley economist writing in the South China Morning Post) speculated recently that: “In China, people make money to, well, make money. Happiness comes primarily from counting the money, not spending it.” The total number of the mythical middle class consumers in emerging markets that obsesses Western analysts is probably exaggerated.
India and China also face infrastructure constraints. Shortages of educated and skilled workers are forcing up labour costs rapidly. Essential infrastructure gaps like transport and power in India will take years to correct. Inflation from imports (energy and commodity costs) and rising domestic costs is driving local currency interest rates up. In China, concern about speculative bubbles driven by debt has led the central bank to both increase interest rates but also limit lending. This may choke off growth. A widening interest rate differential against the US dollar also causes currency appreciation attracting capital flows whilst reducing local currency earnings of exporters.
There are feedback loops. Corporate earning growth in developed countries assumes an increased contribution from sales to rapidly growing emerging markets, just look at the Boeing and Airbus projections. Any slowdown in emerging markets will in turn hit corporate earning in the USA, Europe and elsewhere. Commodity prices and the fortunes of commodity producers are underpinned by the emerging market growth story. In an origami moment, the "flat world" actually folds back on itself.
Some emerging markets are also dependent upon foreign capital. For example, India is running a trade deficit of around 10% of GDP and a budget deficit of around 3%. This must be financed. To date, this has been financed by foreign capital – both portfolio investments and foreign direct investment. Changes in global financing conditions may adversely affect India and its growth prospects.
The additional risks of emerging market investments are also not properly priced. Enforceability of property rights, good corporate governance, equal access to timely, accurate financial information, corruption and political risks are being ignored.
China’s Shanghai market is down about 20% off its recent highs. In late 2007, the Indian market recorded an intra-day move of around 14 % (8% down followed by 6% up) when regulations regarding foreign investment were mooted. Such volatility is de-stabilising.
Tellingly, savvy and well connected investors from Singapore (GSIC and Temasek Holdings (a government controlled investment fund)) are steadily divesting from China and switching to other assets including distressed bank stocks in Europe and the USA.
The risks of the new investment orthodoxy are high and largely ignored. 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."
The decoupling hypothesis may be a mere narrative fallacy where a convincing but meaningless story is shaped to fit unconnected facts.
© 2008 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).