The credit glut that has sustained the global economy for the past five years is coming to an end. Japan, Europe and the US are all raising, or about to raise interest rates, cutting off the world's supply of cheap money. This will have far-reaching consequences for three investment trends in particular, says unconventional fund management group, Bedlam Asset Management. While we don't necessarily agree with all of the group's conclusions, we still think it's well worth a read...
For most economies the last five years have been exceptionally benign, because the world has been flooded with paper. The amount of money in circulation, from banknotes to more complex money supply data has, in most countries, increased by between a half and 200%. As a consequence, given that funny money has to find a home, almost all asset prices have risen. Those of bonds, equities, housing, commodities and collectables have been propelled to unimaginable levels; in most countries, personal and corporate wealth has never been greater.
The problem is that this very benign background, rather like God making headlines, is unusual. Every investor is well aware of the peculiar symbiotic relationship between America and China. The former runs excessive deficits on the government and current accounts; the latter happily funds these through vast purchases of US Treasury bills. This enables the American consumer (with his record low savings) to buy more Chinese manufactured goods. As a global financial system, it is not without merit. All it requires is that both countries operate with interest rates substantially below any rational level, and that the demand for credit from other nations or corporations bumbles along at sub-optimal levels, as has been the case. This has now ended.
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The first three screws.
The first turn of the screw has come from Japan. Much has been written about China's massive ownership of US T-bills slightly below $300 billion at the end of the 2005, yet the big beluga has always been Japan, whose holdings at the same date were just below $700 billion. Given that between 1990 and 2002 the Japanese government took every possible step to ensure that a mild recession turned into a prolonged slump, the naturally massive Japanese current account surplus and excess savings were the most important props of America's debt-fuelled growth. Despite the ephemeral shakeout from the (probably corrupt) Live Door scandal, there can be no doubt that Japan's propensity to fund America's overspend has ended. The Bank of Japan has clearly decided to reverse a highly accommodative policy - flooding the system with as much money as required - and will soon raise interest rates. The market is not really expecting this; the futures market to March 2007 suggests only 0.7%. However, given very robust GDP, consumer and capital investment data for both the last quarter of 2005, and accelerating into 2006, Japan Inc will shortly need the money at home. It is unusual be so pedantic, but the Japanese futures market really is the wrong price; the surprise in the next two years is that interest rates will probably be twice the rate implied by the futures market.
The next turning of the screw is the European Central Bank. Although a cumbersome and opaque body, the ECB is clearly concerned that Europe may actually show some positive economic growth; thus it too will soon raise interest rates. Across the great pond, where much of America's economic data is robust, the new Chairman of the Federal Reserve Board, for all his helicopter money' rhetoric, clearly wishes to stamp his own brand of financial discipline on markets by being tough'; so the market is going to be unpleasantly surprised by the fifteenth and sixteenth consecutive rises in the Federal Funds rate.
.and a fourth
To this unhelpful brew of more expensive money must be added the sea-change in corporate thinking, from America to Europe and Japan. The last five years have been all about restructuring, downsizing and paying money back to shareholders, either through dividends or share buy backs' (a fiction, for another time). It is axiomatic that most shareholders actually have no idea what they want and will forever be reactive (see POTWs previous on the idiocies of fund management). However, even the dullest institution, clamouring for return of capital and larger dividends, has realised that handing money back at the cost to capital investment, thus future growth, is a finite game. Therefore the new fashion as always at the top of the cycle is to encourage companies to cease denuding their balance sheets and to borrow again; hence corporate bond issuance in many countries is rapidly heading north, further impelled by finance directors recognising that the era of cheap money is over; thus better to borrow now relatively cheaply, than to wait pay more. The bond markets, as ever the prime drive of equity prices, are in some respects anticipating this. Much comment has been made on the fact that the spread of US 10 year treasuries over those with a two year duration is negative, often the lead indicator of a recession or at least a slowdown. In the less disciplined world of equities however, the markets are clearly in denial.
The consequences 1. Commodities
The gross value of Over-The-Counter, hard commodity derivative contracts in the commercial banking system had by the end of the third quarter of 2005, reached nearly a trillion dollars (excluding gold). In 2001, the value was a mere $100 billion. Whilst the commodity markets were undoubtedly propelled then by a lack of capital investment, thus caught on the hop particularly by the surge in Chinese demand, the prime drive is now cheap money and speculation. Given that for most commodities (excluding bullion and food) very high prices have lead to much higher capital expenditure, exploration and thus shortly, production, then the supply/demand imbalances will soon dissipate. As most of this punting is on borrowed money and its price is set to rise (as availability falls), so overall the commodity markets are clearly not the place to be. Such a view is confirmed by Britain's Alternative Investment Market. In 2004 and 2005, over half the new issues were commodity related, and the number doubled each year. The commodity cycle is clearly well discovered and very mature.
Despite Iran, the imminent OPEC meeting and Venezuela's mad Hugo Chavez baying for the strangulation of America (also God driven, apparently), every day this year oil production has been running at half to one and a half million barrels more than demand; hence American and global crude oil inventories are close to, or have burst through, previous record highs. There is nowhere left in the world to store oil, yet the world has never been more bullish about the price.
2. BRICS
The most obvious asset class to unwind on more expensive money and a recovery in Japan and Germany are the BRICS. It is quite likely that well-informed readers have no idea what a BRIC is; the latest ersatz investment fad, created by we financial genii to sucker you into your parting with your money. The acronym stands for Brazil, Russia, India, China and former Soviet fiefs, whose new, exciting and dynamic economies will shortly rule the world. We would be very excited about selling you BRICS as well, were it that most of these markets have doubled, tripled or more in the last three years. To focus in on just one, India, the SENSEX index since the second quarter of 2003 has risen from just over 3,000 to 10,000. Overlay the index chart with the net foreign equity buying, much of it fuelled by cheap money on margin and abnormally suppressed bond yield spreads, then the fit is almost perfect. Industrial growth in Germany, and especially in Japan peculiarly knocks the prime prop away from the Indian stock market story as money is diverted back home.
3. Takeovers
Perhaps the most important consequence is a gradual end to takeover fever. As companies reduced their borrowing, paid shareholders more in dividends and stripped away all surplus fat, they became very attractive targets, especially to private equity buyers funded by overzealous banks. Global corporations have now changed direction and are gearing up, investing more and have even become predators themselves; perversely, these factors will cause takeover fever to wane. As a bidder, it is unattractive to take over a highly borrowed company in the middles of a capex spree. Moreover, the cost of such highly leveraged buy-out deals has already risen in practice by 50% in the last two years through interest rate increases, while the share price of the median target has also risen by a similar amount. Simply put, a typical takeover today costs twice as much as it did in 2003.
So panic now before the rush?
It's an option, but like avian flu regulations, probably an ill-advised policy. The standard role of financial advisors is to extrapolate past returns into the future when they have been good; or when they are poor, to highlight the green shoots of recovery. If both stratagems fail to cut the mustard, then it is vital to fall back on meaningless mantras such as over the very long term..'. In contrast, we would suggest as follows. You are close to an optimum moment to dump all index tracker funds. Trackers are paid to track down, as well as up. Commodity investors, with the probable exceptions of bullion and some soft commodities, are likely to be very ill. Portfolios invested in takeover stories' will be surprised by a very low success rate, whilst those banking on even lower yield spreads than recent historic anomalies, will be mulched.
There are over a 100,000 listed instruments in the world. We have no idea where even a thousand of them are going, so as never before it makes sense that investors focus on those companies with clean balance sheets, expanding margins, growing free cash flow and franchises which are difficult to replicate. These companies exist in abundance; unfortunately they largely exclude banks, insurance, pharmaceuticals, commodities, retailers and housing and related industries. In every market these constitute the majority of the national index.
First published as Bedlam Asset Management's 'Pick of the Week'
For more from the unconventional fund management group, visit Bedlam
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