Most City people seem pretty relaxed about this month's shake-out in the markets. The general view is that it was overdue. Investors had become so complacent about risk that they hardly cared whether they were buying an emerging market bond or a blue-chip share, just so long as it offered a yield. Hedge funds had acquired such a taste for exotica that they had started sniffing around countries not usually associated with red-blooded capitalism. One fund recently sought help financing a real-estate investment in Cambodia. So the last week has been a much-needed reality check.
Hedge funds helped drive the markets up and will largely determine how far it falls. So far, the shake-out in the UK market hasn't been that dramatic.
At less than 10% to date, the fall doesn't even qualify as a proper correction. That could change if hedge funds become forced sellers. But there's not much evidence of panic yet. Sure, some funds have taken a nasty knock. There's talk of some being down up to 6% in May. But most funds got off to a rip-roaring start to the year, with most up 10%-15%. They could afford to give a bit back.
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The investment banks say that there's been no big rise in margin calls, which might force funds to sell assets in order to put up collateral for risky trades. Nor is there any sign yet of a repeat of last year's difficulties, when half the industry seemed to be wrong-footed by the downgrade of General Motor's bonds, which caused a popular trade to blow up. That said, with funds making so much use of derivatives to make highly leveraged bets, it's impossible to know what trouble lurks beneath the surface.
Perhaps the biggest risk is that investors in hedge funds will decide to take money off the table, which could force funds to liquidate their investments to raise cash. That could be a particular problem for those funds that allow investors to withdraw cash once a fortnight, or once a month. But 65% of hedge-fund investment is provided by specialist fund of funds. They are unlikely to panic at one month's poor performance.
That's why there have even been some smiles in the City this week, particularly on the faces of private-equity folk. Over the last few months, they've found it hard to get deals done. Look at the failure of bids for HMV and Mitchells & Butlers. They hope that, now the markets have had a fright, investors may not be so quick to tell bidders to push off. But will they be smiling for long? Much depends on how long the debt markets remain open for big leveraged deals. Nervous investors should note that in the US, the smart money is piling into distressed-debt funds. This month's shake-out is an early-warning signal that tougher times may lie ahead.
Why now is the time to invest in Diageo
For investors, the market shake-out should prompt a rethink. Companies exposed to emerging markets may be faster growing, but as this month has proved they are also riskier. Yet many have been valued at a premium to safer European companies. Now it is time to take a closer look
at companies in mature markets that may not grow as fast, but make excellent profits and throw off cash. A case in point is Diageo, the spirits group, which has tended to be overlooked recently as investors have chased more glamorous drinks companies, such as SABMiller, the emerging market brewer.
But Diageo's moment may finally have come. It has some of the best brands in the business, such as Bells and Johnny Walker whisky, Smirnoff vodka and Gordon's gin, and is exposed to the growing US market, where Americans are switching from beer to spirits. Best of all, it throws off cash at such a rate that it doesn't know what to do with it. It is too big to buy anything without running into regulatory problems, so instead it is giving the cash back to shareholders, via a chunky dividend and share buybacks, currently worth £1.5bn a year and likely to continue. That gives Diageo an effective payout of 9% a year not bad for a company growing sales at 4% a year.
Bernanke learns to be opaque
Loser of the week is undoubtedly Ben Bernanke. History will surely relate that it was the Fed chairman's comments to a journalist at CNBC that triggered the market rout. Less than three months into his new job, it was an awesome reminder of the power he now wields. Bernanke was trying to clarify what he had told the markets following last month's US interest-rate rise. But all he succeeded in doing was sowing confusion about whether he was really committed to fighting inflation. The result was hundreds of billions of dollars wiped off markets. Bernanke has now admitted he made a mistake. But it will take him a while to regain the confidence of the markets and even longer to be forgiven by those who have lost a lot of money. Now he must realise why his predecessor always talked in such opaque terms.
Simon Nixon is executive editor of Breakingviews.com
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