The risks and rewards of investing in 2007

Each year the gap between the fears expressed by opinion formers and the risks discounted by financial markets get wider and wider. While commentators have become increasingly alarmist the markets have been ever more serene. The start of this year is no exception.

Economic optimism is well-founded in 2007, but the geo- political risks are heightened.

The headlines and opinion formers are not short of topics to make us anxious. There is an arc of instability running from Afghanistan, through Pakistan, Iran, Iraq, Syria, Lebanon to Israel. In each theatre the situation deteriorated last year. The Taleban are resurgent in Afghanistan, President Musharaf has failed to quell Islamo-fanatics within his borders, an increasingly confident Iran craves a nuclear deterrent, Iraq descended into civil war, Syria continues to cause mischief in its neighbourhood, progress in Lebanon has gone abruptly into reverse gear and Israel was trigger happy in dealing with threats north of its border. US policy in this area has backfired but the lame duck President Bush does not appear to want to entertain plan "B" embodied by the Iraq Study Group's findings.

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At the same time America's trade deficit widens inexorably and protectionist pressures are mounting. US economic activity has been underpinned by unprecedented levels of public and private borrowing. Meanwhile falling house prices and globalisation induced job insecurity have contributed to high levels middle class economic anxiety. Yet stock prices in the US are close to all-time highs. The risk premiums to cover the possibility of default that corporations and developing countries have to borrow money are at or near historic lows. Meanwhile the estimates of volatility of stock prices, bond prices and foreign exchange rates calculated from options prices are near record lows.

Investing in 2007: geopolitics still influenced by fallout from 9/11

How has this divergence of views between the commentariat and the markets come about? The source of the divergence was the epochal event on September 11 2001. The US engaged in two policy responses. In foreign policy it took a more pro-active stance described as the War on Terror, engineering regime change through the overt use of military force. But this policy has had unintended consequences. The Middle East and its neighbours are now considerably more unstable than in 2001. In particular President Bush has done more to help the Islamic Republic of Iran to achieve its objectives than anyone else in 27 years.

When the Ayatollah came to power in 1979 the objectives were simple; neutralise the military threat of Saddam Hussein, extend the Shia revolution and its brand of Islamic fundamentalism and propagate the view that America is the "Great Satan" in the region.

The other policy response has been more successful. Following the 9/11 attacks the US administration was determined that the assaults were not going to propel the US economy into recession. In response to the destruction of the Twin Towers the Federal reserve cut interest rates from 3.5% to 1.75% in the space of three months. Monetary policy remained accommodative with the key Fed funds rate reaching a low of 1%, while the first interest rate hike post-9/11 was over 33 months after the attacks.

So despite all the adverse news on the political front, the world economy in aggregate grew more during the last five years than in any five year period since the second world war. The Federal Reserve's highly accommodative monetary policy was crucial to achieving this. If US interest rates had not stayed low, the economic boom in China would not have been so virulent.

Even today the US is enjoying a happy combination of relatively low inflation and 4.5% unemployment and has not suffered a deep recession for a quarter of a century. It follows that given the tendency of markets to extrapolate from recent experience, there is considerable optimism embedded in financial market prices right now.

Investing in 2007: how robust are stock markets?

Meanwhile some of the divergence between the media editorials and the markets reflects the fact that markets focus on specifics. September 11 may have been an epochal event for the world of geo-politics, but apart from a temporary impact on insurance and airline stocks, the event did not have a lasting impact on corporate cash flows and so did not have an enduring effect on market valuations. It is entirely appropriate for the markets to recognise at sometime that even events of great historical importance may not affect the value of particular assets, indeed the Fed's loose monetary policy had in the long run the impact of lifting asset prices across the board.

Meanwhile the financial system is much more robust than it was ten years ago. In September last year Brian Hunter, a natural gas trader for the Amaranth hedge fund lost $6bn, a colossal amount of money to lose. (See: The life of Brian: how the Amaranth trader lost $6bn.) It surpassed the losses at Long-Term Capital Management (LTCM), the hedge fund that Wall Street banks put up $3.6bn to rescue in 1998. Back then this was a serious matter for the Fed, but the distress caused by huge losses at Amaranth was absorbed without disruption to the overall financial system. There were plenty of banks and hedge funds around willing to buy up Amaranth's assets at bargain prices. Indeed these greatly enlarged pools of speculative capital act to reduce market volatility by pouncing any time an asset price gets significantly out of line. The problem is that institutions have in turn felt more comfortable in taking positions they might have been reluctant to hold a decade ago.

The markets also point out that those headline writers who are excessively pessimistic have "cried wolf" too often. It is an easy path for editorials to predict a disaster. If a disaster occurs, it is foretold. If it does not, credit can be given for a timely warning or simply the readers forget about it. On the other hand markets are often complacent at the moments of greatest danger. Over the last 20 years the markets have been taken by surprise by the October 1987 stock market crash, Russia's default in 1998 and bursting of the dot.com bubble. So the media are too pessimistic and the markets are too complacent, the truth lies somewhere in between.

Investing in 2007: what are the biggest risks?

Here we try to assess where the greatest danger lies. Our first port of call is the UK housing market. Pundits have been calling the imminent crash in the UK property market for over ten years now. The higher the house prices rise relative to income, the more nervous commentators have become. However as we argued last month for the housing market to fall it must be the victim of the economy not its assassin. Every previous crash in UK house prices, in the early 1930's, 1973-76 and the early 1990's has been accompanied by a severe recession. Indeed the crash of the early 1990's followed the doubling of interest rates to 15% and a near doubling of unemployment. With monetary policy in the capable hands of an independent Bank of England, there is no reason to believe a house price crash is imminent.

Another potential source of instability is a collapse in the US dollar. The reasons for the US currency's imminent demise have been well rehearsed. America consumes more than it produces and the yawning trade deficit is unsustainable. The dollar, we are told, needs to fall substantially to correct these imbalances. But sizeable US trade deficits have been with us for over twenty years. In the early 1980's, the Reagan administration cut taxes and boosted the defence spending, the budget deficit ballooned and the trade deficit followed suit. Commentators in 1983 said that the US dollar would collapse, instead it skyrocketed. So that in 1985 the dollar was almost at parity with the pound.

The foreign exchange markets have a habit of making mugs out of currency forecasters. We are no exception. In April last year we noted that US interest rates had been raised to a higher level than UK rates for the first time in five years. In the past on the rare occasions when this situation prevailed, the pound had tended to weaken against the dollar. This is what we forecast in April, but it didn't happen. Then in late November last year the dollar was on the ropes and the pound was at a 14-year high, analysts were predicting an imminent breach of the $2 mark. Six weeks on we are still awaiting the move. The lesson is if the world and his wife expect the dollar to fall this year then it probably won't.

What about the world economy? The fact that global growth in the last five years has been higher than for any five-year period since the second world war, it is tempting to forecast that this can't last and the good times are coming to an end. However, the period of greatest risk to the world economy is probably already over. Interest rates may not have peaked in Europe, but the big tightening of US monetary policy, the doubling of oil prices and the correction in the US housing market have now happened. Looking forward, China looks like accelerating rather than slowing in the year ahead as the Chinese government gears up for the 2008 Beijing Olympics. Moreover the freshly refinanced commercial banks will start multiplying the $50bn of capital they have raised from Western investors into new lending of $400bn or more.

Investing in 2007: oil and Islam

Indeed the biggest risks stem not from economics but from politics. There is a risk of an outbreak of a full-scale war in the Middle East perhaps precipitated by a "pre-emptive strike" by Israel on Iran. Although commentators have been alerting us to this possibility for sometime, the risks have increased. As we have discussed above, US foreign policy has inadvertently played into Iran's hands. With oil prices high and Iraq in turmoil, Iran can entertain nuclear ambitions. It is not only Israel that has much to fear from Iran acquiring nuclear weapons, it is Saudi Arabia. Worried Saudi hardliners have indicated that if American troops are withdrawn early as recommended by the Baker report, then Saudi Arabia would have no choice but to intervene to stop Iranian-backed Shia militias butchering Iraqi Sunnis. The US and Mr Blair have made it increasingly clear that they will be backing the Saudis. Consider the Prime Minister's personal intervention to close the SFO investigation into alleged bribery of the Saudi Royal family and his Dubai speech in which he called for an "arc of moderation" to pin back Iran's advances in the Middle East. Meanwhile President Bush has ignored the Baker report, whose other advice was to open up diplomatic channels with Tehran, and is indeed calling for greater troop deployments.

Accordingly the revelation that Israel has plans for a nuclear strike on Iran is not a surprise. Two Israeli air force squadrons are training to blow up Iranian uranium enrichment facilities using "low-yield" nuclear bunker busters. Mossad believes that Iran is on the verge of producing enough enriched uranium to make nuclear weapons within two years. Although the Pentagon is unlikely to give the go-ahead to the use of nuclear weapons, Israel may seek approval "after the event" as it did when it crippled Iraq's nuclear reactor at Osirik in 1981. If this occurred Iran would try to close the Strait of Hormuz, the route for 20% of the world's oil. The implications for the world economy would be very serious.

Where investors should look in 2007

But for this catastrophic risk, everything in the global economy looks "hunky dory". So where do the investment opportunities lie? The tide of liquidity has lifted the prices of most asset classes be it property, equities, gilts or commodities. But one sector has been left behind, the prices of shares of larger capitalisation stocks. The FTSE 100 index is currently trading on a historic p/e of 13.3 with a yield of 3.1%, whereas the FTSE 250 index has a p/e of 19.2 and yields only 2.0%.

There are two main explanations for this development. The weak dollar has been partly to blame. Many large cap companies earn a significant amount of their revenue in dollars, either from direct sales or because they deal in dollar denominated assets like oil. Now if we suspect, the dollar might not fall like a stone this year, then larger cap stocks will come back into favour.

The influence of takeover activity has also been important. Although FTSE 100 constituents may have attracted more bids last year than in any year since its inception in 1984, the FTSE 250 series has seen a higher proportion of takeover activity; some 5.5% of its market capitalisation compared with 3% for the FTSE 100 index. The mid-cap index rallied 27% last year to stand more than 50% above its 2000 peak. In contrast the FTSE 100 index closed last year 11% down from its millennial high, rising 10% last year. In fact takeover activity has been a vital factor determining performance within the FTSE 100 index last year. If you strip out the twenty largest mega-cap stocks which are simply too big to be taken over, the FTSE 80 rose by 20% in 2006. But as the average deal size is likely to get larger this year we expect more acquisitions in higher cap stocks.

By Brian Durrant for The Daily Reckoning. You can read more from Brian and many others at www.dailyreckoning.co.uk