Business Times Singapore Investment
There's still life after sub-prime
William R. Thomson
May 15, 2008
IS the earthquake that shook
the world's leading financial markets last autumn over, or are
there still damaging aftershocks to come - in the markets themselves
and in the macro economy? This is the question that The Business
Times put to a group of international investment experts and
the responses in general were encouraging for investors. There
is money to be made even in the immediate aftermath of the crisis,
not least in commodities. But investment strategies need to be
thought out even more carefully than usual at a time such as
this. Our four experts set out their thinking - and their model
portfolios - for the benefit of BT readers.
Anthony: Welcome back to you all. This is
our first roundtable gathering since the roof fell in on financial
markets last year and everyone dived for cover. What we want
to look at today is whether it is safe for investors to come
out again now.
More specifically, is the worst
of the financial system trauma over, especially on housing markets,
and what are you expecting by way of short to medium-term economic
performance in the United States, Europe and Japan? Jesper, I
know we can rely on you to start us off on an upbeat note.
Jesper: US policy makers deserve the Nobel
Prize for applied economics. The policy response to financial
asset deflation was not only extremely fast, but extremely well
coordinated. Of course, US asset deflation will still be a negative
pull on US demand. But the second-round effects of asset deflation
have been contained.
William: Winston Churchill said it best: 'It's
not the end, it's not even the beginning of the end but it might
be the end of the beginning'. We are now about eight months into
the financial crisis and we are seeing innovative moves from
the central banks to liquefy frozen portfolios and at the same
time leading banks are making real efforts to rebuild their balance
sheets, as evidenced by the Royal Bank of Scotland's US$24 billion
rights issue. But the International Monetary Fund reckons that
banks will have total losses of about US$1 trillion and less
than one-third of that has been recognised to date.
The US is clearly in recession
and the recovery seems likely to resemble Japan in the 1990s
rather than the typical quick dip and back to the party. We could
get a brief respite in the second half of this year as the rebates
are spent but any relief will be temporary as the new administration
that occupies Washington in January 2009 will have its plate
full trying to right the economy, and implement its programmes,
in order to have the economy look good for the next presidential
election in 2012.
The next two years are likely
to be sub-par at best. I have seen estimates from Housinger and
Associates where the total wealth losses in the US economy from
housing and equities could total US$13 trillion - that is wealth
destruction on an unimagined scale since the Great Depression.
The US' housing cycle is more advanced than the UK's but foreclosures
are not expected to peak until the second half of the year.
Europe will probably escape
an outright recession but is headed for a real slowdown. The
UK, on the other hand, could easily fall into a recession. Those
parts of Europe that enjoyed a housing boom such as Spain and
Ireland will suffer the same fate as the US and the UK. Germany
never had a housing boom, so will avoid a bust.
Robert: I believe we have seen the worst in
the financial sector, but obviously the economy in the US and
Europe may still experience further slowdown, job losses, consumer
spending reduced, high petrol and food costs etc. However, in
general, I am optimistic about the way the world outside the
USA is going, especially Asia, even Japan now, and especially
the Gulf and the oil-producing areas such as Russia and some
of the African countries, Brazil and all the beneficiaries of
the long-running commodity boom.
We cannot say that the worst
of the housing market problem is over yet in the USA, and especially
not in the UK, Ireland and Spain, but I think that the press
has somewhat exaggerated the problems. Especially in the USA
which is a vast economy with local property markets, things are
not as bad as they appear. Sub-prime was 10 per cent or less
of the local property market. Most Americans were not borrowing
beyond their means and the minority who did have already suffered.
Same in Britain.
But on the other hand, the
US corporates reporting first-quarter earnings have come in quite
comfortably, up an average of 10 per cent (outside the financial
sector) and the market is now beginning to re-price on this more
positive basis. This will feed through into rising markets around
Christopher: The Bear Stearns event has removed
market concerns about systemic risk for now. But the worst of
the Western financial crisis and the US and European housing
market distress are both NOT over yet. US and indeed global economic
growth are going to slow down.
Anthony: How do you see the short to medium-term
economic outlook for emerging economies - those in Asia especially?
Do you accept the idea that Asian emerging economies in particular
have 'de-coupled' from those of advanced industrial nations?
Jesper: The world economy is a highly integrated machine
now. The problem is not de-coupling of growth but de-coupling
of inflation. Unfortunately, the integrated global economy is
hitting resource constraints, shortages of energy, water, even
food. On this front, de-coupling is probably impossible. Inflation
in Asia is a much bigger worry than growth - particularly since
policy makers don't
really know how to control it.
Christopher: It is a cycle too early for the emerging
markets to decouple completely from the standpoint of their domestic
demand engines. Consumption in the BRIC (Brazil, Russia, India
and China) countries was last year about 33 per cent of US consumption,
up from 19 per cent in 2002.
Asian economies cannot yet
fully decouple from a US consumption-led slowdown, but nor will
they suffer a correlated train wreck. Rather, Asia will experience
an incremental decoupling from the problems in the Western world
as the region will survive, better than expected, the stress
test of a US slowdown. The key point is that Asia is not dangerously
leveraged, be it at the government level, the corporate level
or the consumer level.
Robert: For the emerging economies, especially in Asia,
we cannot say that they will ever 'de-couple' from the Western
world, because the global market is more closely correlated,
not only in terms of capital but also in terms of trade today,
than ever before. For instance, China's foreign trade is more
than 60 per cent of GNP, from a negligible proportion 25 years
But there is a visible and
accelerating shift of wealth and industrial production from the
West to the east, especially the greater China region and also
the Gulf. This means that spending on infrastructure by governments
in China, India, Saudi Arabia, the UAE and other nations presents
a serious counterweight to the slower growth in Europe and North
America. Consumer spending in these
nations is also a significant new factor of demand.
However, I believe that we
have to study carefully the case of Japan, which was in this
phase of confident expansion in the 1980s and has now been, for
close on 20 years, in a phase of recession, mainly due to demographics,
as well as due to disappointing macro-economic management. The
key is government policy in taxation and encouragement of foreign
investment and trade. China will not, I believe, make the same
mistakes as Japan.
William: The outlook for emerging markets
varies as to whether they are running a current account surplus
or not. Asian emerging economies generally have a strong external
balance, based either on industrial and service exports, as is
the case of China and India, or commodity exports, as in the
case of South-east Asia. Sure, the global slowdown is affecting
them to a degree but their growth rates are still high enough
to make the rest of the world green with envy. The Middle East
oil exporters are in a similar happy position.
But emerging economies running
current account deficits, as in the case of Iceland, parts of
Estern Europe and Turkey, for instance, are quite vulnerable
to nasty surprises in terms of currency devaluations and access
to foreign credit as a result of the new-found desire to minimise
risk on the part of financial investors.
Anthony: Let's talk more about inflation.
How serious a threat is it, for advanced and emerging economies
alike, or is it more likely to be a case of 'stagflation' in
the advanced economies?
Robert: Inflation is a serious threat and when we see,
for example, Vietnam suffering inflation of over 20 per cent,
we must recognise that this poses social and political problems
as well as economic dislocation. The opportunity in this inflationary
crisis is, to quote a Chinese sage 'to invest in the earth' for
the next five years, which means energy, minerals, real estate
and agriculture. Everything we buy in our portfolios should be
an inflation hedge. For this reason, I think Australia still
remains an attractive market, because of its strong position
geographically and in terms of resources.
William: The threat of inflation, in my opinion,
has been systematically underestimated by complacent governments.
They misunderstood the threat presented by the late credit boom.
The obsession of central banks with targeting 'core inflation'
and ignoring growth in money supply are now catching up with
them. The US Fed has been most guilty in this regard. M3 in the
US, which is no longer officially measured, is now estimated
to be running at over 17 per cent and the CPI, under the pre-Clinton
measuring methodology is running at 7.5 per cent, even the new
official (manipulated) rate is 4.1 per cent. The recent lowering
of interest rates means real interest rates are substantially
negative, thereby feeding further inflation.
Emerging markets that have
underpriced their currencies by tying them to the US dollar are
similarly importing inflation. With the recent explosion of food
and oil prices, there is now a real threat of a wage price spiral
developing in the developing world. We are, I fear, facing a
replay of the stagflation of the 1970s. Inflation will ultimately
be seen as the easiest way out for the over-indebted consumers
in the US and the UK.
Christopher: If the trend in food prices continues
in its recent parabolic fashion, this has negative implications
for Asia consumption. But my advice for investors in Asia is
to not get too freaked out by the food-price scare. The Billion
Boomer story, propounded by CLSA since 2002, is about investing
in Asia's rising middle class, not about people who cannot afford
a bowl of rice. The risk, if there is one, is clearly political
instability caused by food riots.
Anthony: How long can the commodities boom
- in energy prices especially - persist, and what are the implications
for investment in commodity funds (including foodstuffs)?
Jesper: Commodities remain the prime focus
in the 21st-century globalisation race. As middle-class societies
grow in Asia, in Latin America, in Russia and, hopefully, even
in Africa, the world will have to become extremely creative and
innovative to overcome increasing supply bottlenecks. So I would
be long commodities, yes; but I would also be long the top innovation
powerhouses. There will be technological revolutions that we
cannot even dream of right now - precisely because commodity
prices will keep on rising.
Robert: When I study the market for natural resources,
for example demand for Australian minerals, I am confident that
we are still in the early stages of a 20-year cycle, because
India will come after China in terms of infrastructure spending,
automobile sales, electricity demand and other key factors. I
am very doubtful that the US$120 a barrel price level will persist
for long, and I think it is due to speculation and artificially
constrained supplies in Iraq, Nigeria etc. My expectation is
that we will see oil trade back to a mean reversion price of
perhaps US$80. This may have a secondary effect on food prices
(especially rice) which have been artificially boosted in the
first quarter of this year.
William: Without doubt there is frothiness
and speculation in the commodities markets. In general, I do
not believe we have seen the ultimate tops in these markets but
I expect much greater volatility than heretofore. There is now
an abundance of ways to access these markets from hedge funds
to exchange-traded funds (ETFs), the latter allowing a low-cost,
efficient means to access the markets on an un-leveraged basis.
But the ETFs themselves are an element in the speculation. With
regard to foodstuffs, public policy has been abysmal with its
promotion of biofuels, probably one of the greatest domestic
policy errors in decades. Most biofuel programmes make absolutely
no economic sense since, in the case of corn especially, their
production results in a negative energy balance plus the water
table is drastically undermined.
Christopher: The commodity trade, though still
a structural bull story based on rising emerging-market demand
and real supply constraints, will suffer a sharp bull-market
correction when the commodity complex finally succumbs to the
deflationary implications for global growth of the continuing
credit crisis. Such a commodity correction will go hand in hand
with a US-dollar rally since the commodity strength of late has
increasingly reflected US dollar weakness.
Anthony: So, should the optimum investment
stance now be cautious (cash or gold as 'king', or defensive
bond market investments) or aggressive to take advantage of possible
opportunities thrown up by equity market and other asset price
William: Not bonds and certainly not US dollar
bonds. The long bull market in bonds that dates back to Paul
Volcker's reign at the Fed has ended in my view. On top of that,
the long dollar bear market is not yet complete although it is
getting long in the tooth. Even Treasury-indexed bonds are a
no-go area given they are tied to the grossly understated CPI.
Cash has a role as a temporary
haven so long as it is not in the US dollar. The equity markets
have pockets of interest: oil majors for instance with secure
dividends and ultra low PE ratios but in general the US and UK
markets probably have to absorb a lot of negative news on earnings
over the next few quarters.
Some emerging markets have
come off a long way and the brave can venture in. Others, such
as Thailand, have very low valuations and far more opportunity
than risk at these levels. ETFs and ETNs offer a convenient way
in as do hedge funds and funds of hedge funds. But, in general,
I fear we that are in a period like the 1970s when the markets
range for many years and go nowhere as price/earnings ratios
fall. That is the price of stagflation. Gold always has a place
in these troubled times and is a fine piece of insurance. I do
expect it to go higher over the next couple of years.
Robert: I see that many US investment managers are
now aggressively long, and have a 75 per cent in equities and
(for the reasons outlined above, that is, higher inflation),
would be reducing, or avoiding fixed income markets. This is
also my view, and I think on past experience that the 'inflation
hedge' markets (and this includes Hong Kong) will do well this
year. Japan might surprise us with higher interest rates, stronger
yen and a stronger equity market in 2008-2009. I would not be
defensive right now, although I believe gold will reach US$2,500
within 3-5 years, it has had a good run and is now in a correction
phase. The opportunity is in other asset classes.
Jesper: This is a good time to take risk. Real interest
rates have been pushed into negative territory almost everywhere
on the globe, except Europe. We're on the brink of a spectacular
bull-run in risk assets. However, watch the policy response to
inflation. That will be the bell that marks the end of the run.
Right now, however, we're just getting going.
Christopher: Much depends on the view taken. But
investors should invest a certain amount in Asian equities each
month since there is likely to be an extended consolidation.
Anthony: How would you construct a portfolio
now in terms of proportionate investment in cash, gold, bonds,
equities etc? Are there any particular sectors or markets that
William: For an Asian investor, I would have
15 per cent in gold and silver ETFs, 20 per cent in energy equities
and commodity ETFs or preferably hedge funds, 10 per cent in
non-US dollar cash, 30 per cent in Asian equities and the remainder
in US and European equity ETFs. US property and financials should
be your watch list but it is still too soon to move in my opinion.
Robert: I would be 75-80 per cent in equities, with
the balance in cash. I like banking and financials because they
are so oversold. I like the technology sector, which everyone
is also underweight and expectations are low. We have seen many
good companies (Samsung, Google, Apple) reporting higher-than-expected
earnings in the past few weeks and I believe this sector will
outperform in the next 12 months.
Christopher: My recommended long-only global portfolio
for US dollar-based long-term global investors would be as follows.
(This is a long-term portfolio, which seeks to balance the long-term
risks and opportunities in the current global context). 20 per
cent in US long-term treasury bonds, 15 per cent in gold bullion,
15 per cent in unhedged gold mining stocks, 15 per cent in Asian
physical property (including Japan), 5 per cent in German physical
property, 15 per cent in Asia ex-Japan equities, predominantly
invested in domestic-demand and asset reflation names, 15 per
cent in Japanese equities, primarily in domestic-demand names.
Anthony: Thank you all and it's nice for investors
to hear that there's still life after the sub-prime debacle.
Jesper Koll is president and chief executive officer
at Tantallon Research, Japan.
Robert Lloyd George is chairman and CEO of Lloyd George
Management, Hong Kong.
William Thomson is chairman of Private Capital Ltd,
Hong Kong and senior adviser to Franklin Templeton Institutional
Hong Kong and Axiom Funds London.
Christopher Wood is managing director and equity strategist
at CLSA Asia-Pacific Markets in Hong Kong.
Anthony Rowley, Tokyo correspondent for The Business
May 14, 2008
William R. Thomson
Business Times Singapore