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Business Times Singapore Investment Roundtable
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 the world.

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 ago.

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 falls?

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 you like?

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 Times

May 14, 2008
William R. Thomson
Business Times Singapore
email: wrthomson@btconnect.com

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