Business Times Singapore Investment
The beginning of the end?
William R. Thomson
Jun 26, 2007
The bull market appears to
have peaked and a major correction in global bonds and equities
is looking more likely, say panelists
Moderator: Anthony Rowley, Tokyo correspondent for the Business
Marc Faber, investment adviser and publisher
of the 'Gloom, Boom and Doom Report'
Mark Mobius, president of Templeton Emerging Markets
Fund Inc, and director and executive vice-president of Templeton
William Thomson, chairman of Private Capital Ltd in
Christopher Wood, managing director and equity strategist
at CLSA Asia-Pacific Markets in Hong Kong
LIKE the often-prophesied end
of the world, a major correction in global bond and equity markets
is a long time in coming - so much so that many investors are
tempted to think that it may never happen. But, as two of our
eminent investment experts comment in the panel discussion below,
the most dangerous words in the English language are: 'This time
it is different.'
The 20-year bull market in
bonds is already looking very shaky, following recent sharp rises
in government bond yields. While the market unwinding is unlikely
to happen overnight, the implications for ultra-narrow credit
spreads in general are clear to see. As central banks tighten
monetary policy, in belated recognition of rising commodity and
asset prices, the liquidity bubble that has propelled markets
- emerging markets especially - to record highs is expected to
burst. The correction could be savage, as our panelists point
Anthony Rowley: We're privileged to have some of
the best in global investment talent taking part in this Investment
Roundtable, at what could be a critical turning or tipping point
for bond and equity markets.
Our panelists are veterans
on the world investment stage, and also in these discussions.
A very warm welcome back to all of you. Marc, let's throw the
ball into your court first. Does the recent sharp rise in bond
yields signal the beginning of the end of the sustained global
bull market in bonds, and possibly a bear market in equities
Marc Faber: We had a more than 20-year bull market
in bonds - Sept 21, 1981, to June 2003 when the 10-year (US)
Treasury bond yield fell to 3.3 per cent and the JGB (Japanese
government bond) yield fell to less than 0.5 per cent. We are
now at the onset of a major bear market in bonds worldwide that
should bring interest rates above the level in 1981 when US Treasuries
were yielding over 15 per cent. But this process will take at
least 10 years. In this environment stocks will not do well in
real terms but will rise in nominal terms. How high will depend
on (US Federal Reserve chairman Ben) Bernanke's money printing
William Thomson: I believe the bull market in US Treasuries
that began in 1980 peaked in 2003 and that we have been in a
long-term topping action since. The recent rise in interest rates
indicates that bond prices are probably moving into a lower trading
range with higher yields than we have become accustomed to. Central
banks have been behind the curve in raising rates and until recently
they were beguiled by phony, low-inflation numbers. As a result,
real interest rates, after adjusting for inflation, have been
too low. Commodity price inflation (in terms of food, energy
and minerals) is now seeping through the global economy and boosting
even government-manipulated inflation readings. Thus, interest
rates are rising as central banks take belated notice. Equities
are overbought short-term and due for some consolidation.
The exact timing of a bear
market will depend on many factors in individual markets including,
but not limited to, interest rates. A bear market next year would
not surprise me since the global expansion will be very long
in the tooth by then, and markets will be trying to assess possible
changes in US fiscal, monetary and possibly protectionist policies
in 2009 with a new US administration.
Christopher Wood: The 10-year US Treasury bond yield
has broken above the long-term trend line, in place since the
beginning of the great bond bull market back in 1981. The recent
equity rally has occurred in the context of rising government
bond yields, just as the sell-off in February/March occurred
in the context of falling bond yields.
All this suggests that the
Fed model, where hundreds of billions of dollars of portfolio
capital is allocated globally on the relationship between bond
yields and earnings yields, has broken down.
Anthony: Even so, it is often argued that
a 'new paradigm' is at work in the equity and bond markets -
one that has invalidated past investment cycles and boom and
Mark Mobius: Someone once said, 'The most expensive
words in the world are: This time it is different.' There is
no new paradigm at work in equity and bond markets which would
invalidate past investment cycles and boom and bust theories.
The nature of markets is such that there will always be excesses
in bullish moods and bearish moods. In 1999 and 2000, the majority
of investors felt that we had entered a new paradigm and earnings
did not matter but the 'burn rate' (the speed at which companies
could spend and expand) was more important. Of course that mania
resulted in disaster for many investors.
William: I agree. That long bull market seems
over and we may enter a bear market or a longer trading range
at higher yields than in recent years, reflecting higher underlying
Marc: There is no new paradigm but there are central
banks that expand money and credit at a fast pace and create
'excess liquidity'. This is particularly true of the US Fed,
which through its expansionary monetary policies led the US to
have a close to US$800 billion current account deficit, which
then leads to a 'savings glut' and excess liquidity around the
world. This liquidity then drives all asset markets, including
stocks, commodities, real estate, art, collectibles, and even
until recently bond prices, higher.
Anthony: If the music has to stop, or the
tempo to slow sharply, when is that most likely to occur?
Mark: No one knows when the music will stop and the
party end. Normally, however, when everyone is unanimous about
the viability of the market and the impossibility of it going
down is when the market will probably crash. It's just like when
you have a party with lots of alcohol. Everyone is happy and
gets drunk. They feel wonderful and the world is bright. Then
the alcohol wears off and you wake up with a hangover. It's all
William: My crystal ball is cloudy right now.
This upswing has been very strong globally. The imbalances we
have talked about remain but have not as yet caused real upsets.
But they will have to correct sometime, either violently or gradually.
My best guess is that the new US president - if there are tax
and other policy changes in 2009, the markets will begin to anticipate
them ahead of time, probably in 2008, maybe later this year,
adding uncertainty. On top of that, the Chinese may want to cool
their economy after the Beijing Olympics. Higher interest rates,
in the interim, globally should have some dampening impact.
Christopher: The continuing US housing slowdown
could still be the source of a renewed growth scare that will
hit markets in coming months. Rising bond yields would surely
pose a blow for the US housing sector, which continues to deteriorate,
if the breakout on the 10-year Treasury bond yield is sustained.
Marc: It will stop when the excess liquidity gradually
dries up. This can happen for a variety of reasons. Consumer
price inflation could accelerate and economies overheat, thus
draining money from the financial sector into the real economy.
Or it could happen because of illiquidity in the US household
sector, which would curtail imports and lead to the current account
deficit of the US no longer expanding. There are already some
clear cracks in the global asset bubbles: US housing prices,
the sub-prime lenders, investment banks, and most recently, the
bond market. The second half of this year could become painful.
Anthony: What, in your view, is most likely
to be the factor that will precipitate a correction or crash
William: We can only hazard guesses. More than
likely it would be some event that markets cannot discount -
say, an attack on Iran, unrest in China, or protectionist measures
in the US by a new US president as the result of a recession.
If the correcting event is unexpected, and of a major kind, it
could cause problems with derivatives - leading to financial
Christopher: Rising credit spreads remain the
key risk for equities and all other financial asset classes since
they have the potential to bring an abrupt end to the global
credit bubble of which leveraged buyouts have been the latest
most extreme manifestation. Credit is much more mispriced than
Marc: Excess liquidity has been driven by the US
current account deficit growing from 2 per cent of GDP in 1998
to close to 8 per cent now. Growth of the current account deficit
has slowed down as the US consumer is struggling. If US inflation
were properly measured, we would already be in a phase of stagflation
in the US. (The rate of new money flowing into the global system)
has slowed down considerably and so not every asset bubble can
continue to expand. The global bond market was the first casualty.
The reason that other asset
markets have continued to soar is, however, increased leverage
and a flight from cash into assets as people rightly begin to
realise that paper money's purchasing power is collapsing. Therefore,
any catalyst, no matter how small, could one day reverse investors'
expectations and lead to a process of de-leveraging and a collapse
in asset prices.
Mark: The underlying viability of markets is earnings
power. If market participants think they can make profits either
short-term or long-term, they will continue to hold investments
and even invest more. Therefore, we must look for that event
or series of events which lead to people thinking that the ability
of their stocks to make money for them has ended. The perception
of earnings power viability can last a long time but the trigger
that tips the scales and causes people to act can be a relatively
meaningless event which is really unrelated to the market itself.
Anthony: Is it equity or bond markets that
are most at risk of a severe and lasting correction?
Marc: Emerging stock markets are now vulnerable because
they are the most extended. They were the prime beneficiaries
of the excess liquidity.
William: They say in America, when the paddy
wagon comes round, it takes the good girls with the bad.
Christopher: Neither is at risk of a severe and
lasting correction until credit spreads blow. Then only government
bonds will go up.
Mark: Equity markets tend to be more volatile but
even bond markets can take a severe beating in a strong downtrend.
Anthony: Is a correction likely to impact
developed and emerging markets equally and which ones would suffer
Christopher: All Wall Street-correlated stock
markets are likely to be impacted.
Mark: Those markets that have risen the most will
probably suffer the greatest percentage falls, so emerging markets,
since they have risen more than developed markets, should have
William: History would indicate that emerging
markets would be slightly more growth potential and should be
bought on significant weakness.
Marc: Emerging markets would suffer the most in a
global tightening environment coming from the US current account
deficit no longer expanding.
Anthony: What would be the likely magnitude
of a correction in terms of percentage fall?
Mark: A severe market correction could range between
20 per cent and 70 per cent.
William: That is impossible to say. It depends
on the reason for the reaction and will vary from market to market.
Ten per cent is hardly a correction; 25 per cent does not seem
unreasonable; 50 per cent seems far too great unless we have
a true crash, especially as we had one like that in 2001-3.
Christopher: If credit spreads blow, a bear market
would ensue which would mean 50 per cent-plus corrections. Otherwise,
corrections are likely to be limited to 10-15 per cent.
Marc: Once the shares of Goldman Sachs are down by
20 per cent from their peak the phones at the Fed and at (US
Treasury Secretary) Hank Paulson's office will ring asking them
to cut interest rates to support the asset markets. So, who knows?
But in real terms (in gold terms) US financial assets will be
'toast' for a long time.
Anthony: Thank you all, as ever, for a very
stimulating discussion and we look forward to welcoming you back
- before or after the 'crash'.
23 June 2007
Business Times Singapore