Caveat emptor
Spreads may be widening in anticipation of the new issuance season starting this month, but the worsening macro data suggests bond managers can also expect to see an increase in defaults. Some are rightly nervous of cyclical credits and high yield, with Moody’s increasing its global high yield default rate to 2.5 percent in July from 2.1 percent in June.
Yet Luke Hickmore, an investment director at SWIP, says there may be a longer time lag before the defaults come through than in the past, because of the increased use of cheap financing with no covenants: “Triple C-rated bonds usually last three or four years before they blow up. In the 1970s or 1980s you might have had three or four bonds in this grade that defaulted in that time span, but now there are 300 companies in the triple C grade, so default rates will increase.”
The popularity of ‘covenant light’ may stave off defaults until mid-to-late 2009, when economic conditions are tougher and companies are trying to refinance, but Hickmore is expecting a default rate of 10 percent for the end of next year. He also expects to see more problems amongst US regional banks, especially those with only one business, such as commercial real estate: “Those won’t get rescued by anybody. It will be the same if they only have a small number of deposits.”
He points out that the Federal Deposit Insurance Company has already used up a quarter to a third of its total resources through banks failing in the US, so the premiums the banks pay to the FDIC will have to go up next year. “Next year you could easily see an aggressive move by the Federal government to close down some of these ailing banks,” he adds.
Rising defaults
Difficulties are also apparent in certain segments of high yield, with 11 defaults of Moody’s rated issuers in July, the first double-digit monthly tally for five years. All but two of these were US issuers, the exceptions being Canada’s Ainsworth Lumber Company and the French wine and spirits group Belvedere SA. Moody’s is forecasting that the global default rate will rise to 6.3 percent over the next 12 months, and go as high as 10 percent if there is a protracted US recession.
But defaults are likely to be lower in Europe than the US, where high yield issuance is more cyclical and consumer-oriented, so some managers are willing to venture into lower grades. James Gledhill, head of fixed interest at New Star Asset Management, believes the market is discounting too great an increase in defaults: “The ITraxx Crossover is at about 550 now, which suggests that about 18 out of its 50 members will default over the 5-year index, which I don’t think is true,” he says.
“The maximum bang for your buck is to be had by investing in things that trade very wide that other people think will default, so we have a few of those, but in general we are trying to invest a bit back from that in things that trade a bit tighter. It is difficult to argue that it will recover quickly – but you are being paid to wait and there is lower volatility than in equities.” Other managers, such as BlackRock’s Owen Murfin, and Pimco’s Luke Spajic, say they are staying north of Triple B, particularly in cyclicals, which will suffer more as the economy slides into recession.
“The asset class has been shaken to its core,” says Spajic, head of pan-European credit portfolio management at Pimco. “Things are cheap for a reason, and you need to read the tea leaves a bit and understand what has gone wrong.” Pimco remains very defensively positioned, and is accumulating credit slowly. Whilst the new issuance season may provide fresh pickings, secondary trading remains very illiquid.
Hickmore adds: “Even if you’ve got a position in what used to be a triple A insurance-wrapped bond, such as Telereal [a subsidiary of BT] – which has downgraded to double A because its monoline was downgraded – the price hasn’t moved because no-one has been able to sell any. Everyone who wants them has already got them.”
Hamstrung market
The secondary market is still hamstrung by a lack of capacity – over the last year there have been no new entrants to the market, whilst a lot of traders have left post-credit crunch. Banks and brokers are still trying to deleverage and aren’t prepared to house the risk. “So there are few people who are buying, other than the distressed debt buyers who are bottom fishing,” says Adam Cordery, head of European credit strategies at Schroders.
The new issuance season is expected to bring some new names to the European market, with a big issuance backlog, particularly in the banking sector. This year some 75 to 80 percent of new issuance has come from this segment, and September is expected to be no different. But the close of August also saw corporates such as France Telecom, Eon and Daimler come to the euro-denominated bond markets, as treasurers have started to worry that conditions are likely to get worse before they get better, and that banks won’t be in a position to help them, the later they leave it.
This is something of a turnaround, as for a good part of this year issuers have been going to the dollar market instead. “There has been a lot of support for new issues in dollars and they have been able to get decent sizes away,” explains Hickmore. “So you’ve seen Deutsche Telekom, M&S and Cadbury’s do dollars because it’s cheaper and they can get the size they want. But we think that is becoming quite exhausted and now the balance is swinging back to the UK and Europe.”
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The Greatest Fortitude
Value managers have had to have the patience of Job over the last two years – but last month saw the first sign that the market’s fixation with commodity plays may be drawing to a close. The popular short financials/long commodities trade suddenly reversed, but was this just a technical adjustment, or the beginning of the end for the metals and mining story?
Markets have always been susceptible to manias, but the commodities strain has proved unexpectedly virulent, persisting far longer than the TMT bubble. “There are aspects to this market that are extraordinary,” says Paul Ehrlichman, CIO, Global Currents, part of Legg Mason. “If you had just bought what was going up the most, and sold what was going down the most – that gap is wider than at any point since 1927. This has been a very challenging and severe period for value managers, with five and sometimes 10-year track records being threatened.”
Mark Donovan, managing director at Robeco Boston Partners, says that there are normally some low-valued stocks that have attractive momentum characteristics, but in this mania, the spread that investors have been willing to pay for high momentum stocks is much higher than the valuation of medium and low momentum stocks.
In 1998-99, when everyone ran to TMT names, the belief was that the unit volumes of internet usage would explode. This time, it is more of a pricing story than a unit volume story. “But it seems to me that it has to fail, as you can only increase commodity prices so much before demand destruction occurs,” he says. “Farmers can only pay so much for fertiliser, and when gasoline went over $4 a gallon in the US, there was a meaningful decline in gasoline consumption. So the notion that the commodity bubble – which is largely price driven – can continue, doesn’t make much sense.”
Style reversal
Indeed, there is now a sense that style performance is about to reverse, with momentum running out of puff. According to Andrew Lapthorne, of SocGen’s Cross Asset Research Group, valuation dispersion measures suggest that the market is starting to differentiate again, with dispersion reaching levels that would typically imply better value returns going forward. Unfortunately, value styles also remain sensitive to the economic cycle, and tend to perform better when the profits cycle is accelerating rather than decelerating. Value investors will just have to keep telling themselves that the more they suffer now, the better it will be when the reversal finally comes.
As a contrarian manager, Donovan says Robeco Boston Partners looks at companies that are experiencing some stresses, where it feels the problems will work out over time and the market is incorrectly viewing those problems as permanent in nature. This time the lagging stocks have been the financial, property, and consumer discretionary companies such as car manufacturers, retailers and restaurants. “Amongst that large group of stocks, some will prove the diamonds in the rough that have been thrown out unnecessarily by investors,” argues Donovan.
Ehrlichman adds that there are two types of value investor, and each will be attracted to different kinds of stock. The defensive value managers are more likely to buy the laggards in sectors like healthcare, food and telecoms, which should pay high dividends. And the deep value managers will look at financials, consumer discretionary stocks, and tech companies – the really beaten up stocks.
But deep value could face further pain, as it only outperforms when profitability is below trend. “The super-boom in profitability is way above trend so the earnings cycle isn’t yet set up for deep value to outperform,” he says. The problem is that value factors – meaning low P/E, low price to book, and low price to cash flow – tend to be pro-cyclical.
Feel the pain
So although the financial leverage part of profitability has been devastated and is unlikely to see further downwards revisions, there is still pain to come courtesy of operating leverage. “That means the scarcity plays will get hit, and you can already see that with the cyclicals because they are going down. We’re trying to be disciplined. Cyclicals can suck you in on a low P/E – that’s a value trap in a stock that’s down because profits are peaking. But value managers are also inherently sceptical of structural changes in profitability and may not be willing to pay up when profits have improved.”
In financials, he says TD Ameritrade and Fidelity National Information Services are interesting stocks, adding: “We are still concerned that earnings won’t be supportive of many of the out-of-favour stocks – we want more visible and durable earnings.” A deeper value, more out-of-favour stock would be Infineon, the semi-conductor manufacturer, or Cisco: “The IT sector has very depressed profitability and expectations and it has been trashed. But it is focused on free cash flow and share buy-backs – compare that to the massive capital spending in metals and mining.”
On the consumer discretionary side he cites Nobel Biocare, which makes dental implants, as a good example. “This is under new management and is essentially an oligopoly, but it has been ripped down to record low levels of valuation. There are some short-term threats to elective procedures like this and laser eye surgery, but we don’t think it’s quite that discretionary.” Ehrlichman also likes Symrise of Germany, which has been hit very hard. Symrise is a global leader in natural and organic fragrances and flavours, but it has been more than cut in half since its IPO and is trading on a low multiple.
Bear warning
Donovan adds that amongst the financials he is looking at insurers and asset managers now, but warns that in a bear market, financial companies can and do go to zero. Bear Stearns lost well over 90 percent of its value, and IndyMac has declared bankruptcy. “Value investors are naturally attracted to financial institutions but you have to be quite careful. The incidence of financial firms failing is probably higher than that of industrials, as small problems on the asset quality side can become big problems for banks with fairly thin capital,” he says.
“The other problem with investing in financial companies is that there is nothing to look at – it’s a leap of faith in management that they have soundly underwritten their loan portfolio. When credit cycles go bad it’s always surprising how far institutions like Countrywide, for example, have gone into the very shaky credits. They didn’t need to – they had by far the leading market share – and yet they strayed into those areas.” He says that Boston Partners prefers to spread the risk with a range of small to medium-sized positions. “So we own about a dozen bank stocks and if eight of them prosper, two of them do okay, and two of them go to zero, our portfolio will be okay.”
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The Currency Conundrum
Rampant inflation has set the cat among the pigeons for currency managers seeking rewards in emerging markets. The problem is partly that central banks in Asia have failed to tighten monetary policy as expected, preferring fuel subsidies and restrictions on food exports to a modest period of austerity.
Elsewhere, those traders who attacked the Middle East dollar pegs throughout the Spring have failed to break them. But that hasn’t deterred them from trying again. “Just recently we’ve seen an enormous surge in investor appetite for GCC trades especially around the Saudi currency,” says Peter Rosenstreich, chief market analyst at Advanced Currency Markets, an FX broker. The excitement followed a comment by a senior Saudi council member that a 20 percent revaluation of the riyal is necessary.
“This has always been a story that people are watching and many still have this sort of revaluation priced into their macro trade,” Rosenstreich explains. “So every time you have a statement like this, the market regains that appetite. But we believe traders need to temper their reaction right now.” He says the underlying fundamental reasons why policymakers would revalue remain intact, but they are concerned about another bout of dollar weakness and the fact that a destabilising revaluation could complicate the progress towards monetary union in the Middle East. This is despite the fact that inflation in Saudi Arabia is over 10 percent.
An unsuitable peg
In July, Goldman Sachs published a report examining whether the Gulf currencies are more suited to a dollar peg or a euro peg, and found in favour of the latter. In particular, Qatar, Saudi and the UAE all had very low scores for dollar peg suitability. The report argued that the dollar peg is unsuitable for Middle Eastern economies because they also have strong trading links with the Eurozone – so when the dollar weakens, their own currencies depreciate noticeably versus most currencies – especially the euro. This has increased import prices.
Mark Farrington, head of currency at Principal Global Investors (Europe), believes the dollar has now bottomed, “but it won’t rise for a while, so it takes the pressure off the pegged currencies to deal with a moving target”. He says it is fine for small economies to have a dollar peg, as long as they understand that the impact of an adverse movement must be taken through the domestic economy, rather than through the currency.
“In Hong Kong everyone now understands that if Asia has a recession, asset prices collapse in Hong Kong because they have to take the slowdown effects through wages and asset prices domestically rather than through the currency and interest rates,” he explains. “I don’t think the Middle East is familiar with that picture, although in the Gulf the business cycle can be smoothed for the general population via subsidies.”
But over time he expects this to change: “In Dubai there is now a lot of non-Arab money and they are exposed to the same economic forces. So I don’t know how they’re going to cope with a major recession in the Middle East. I think it will be a big boom and bust story.”
This happened in Hong Kong’s property market in the early years of the peg, which wiped out a lot of speculative money. “Then it made a stand and defended its peg and now it is accepted as part of the furniture there. So the Middle East still has a lot of pain to go through before they are as stable as the Hong Kong peg.”
Political pressure
Currency managers like Investec are not optimistic that the Gulf pegs will be abandoned any time soon. “At the moment the political pressure to retain the dollar peg is too high, so it is unlikely that they will move in the next six months,” says Werner Gey van Pittius, emerging markets currency manager at Investec Asset Management. “But we might see the central banks start buying euros. That’s what Russia did when it came off the dollar peg.” He adds that countries like Ukraine, where consumer price inflation is running at over 23 percent, is buying euros with the aim of moving to a euro/dollar basket. When their reserves are 50/50 euro/dollar, they will peg to this basket.
Investec has stayed away from the Gulf currencies because of this uncertainty over the dollar peg: “It uses up your capital and we prefer to play Egypt as a proxy, which runs a managed float,” Gey van Pittius explains. He sees more willingness in Egypt to allow the currency to appreciate and some Middle Eastern countries are re-investing their oil revenues there. “It also has the Suez canal and tourism revenues, so it is a much safer bet, as the likelihood of appreciation is much higher.”
Whilst high yielding emerging market currencies are still paying off for currency managers on the back of strong inflows to emerging market bonds, some analysts are growing uneasy. Jim McCormick, global head of FX strategy at Lehman Brothers, believes that many emerging market currencies are close to their highs, and is far from impressed with how central banks are handling the rise in inflation. “We are also seeing systemic risk increase. Currency weakness is already being seen in Iceland, Vietnam and Romania.” Poland, Hungary and Turkey have also exhibited recent spikes in risk.
PGI’s Farrington points out that the most vulnerable currencies are those where the country is relatively close to a current account deficit and dependent on high commodity prices to keep it above water, especially if it has a large amount of foreign currency debt. If commodities come off, these countries could be looking at an old-school balance of payments crisis.
Currency contagion
One saving grace is that emerging market contagion will probably play out in a more benign manner than in previous crises. He suggests that countries like Venezuela, Argentina, the Philippines, Vietnam and Zimbabwe will break first. “Then you will have the contagion trade, where everyone trades those currencies that look a little bit vulnerable. Next it will hit the stronger emerging market currencies, but they will be able to withstand the attack. So contagion will roll out but it won’t roll very far.”
Instead of chasing the high yielding emerging market deficit currencies, Farrington recommends shorting the Anglo-Saxon business model currencies, such as the Australian and New Zealand dollars and the UK pound, against the US dollar, as their banking sectors will be more affected by the credit crunch. “This should help bring inflation down as GDP will run well below trend for at least a year, it will create an output gap, and this will allow rates to be cut.” In other countries, however, inflation is unlikely to come down far enough to allow their central banks to cut rates.
He adds that currently, the currencies that get punished the most are those where the central bank is given the freedom to cut interest rates. He points out that the South African rand is rallying, regardless of the negative underlying fundamentals, because the central bank is tightening. “Whereas Australia has fantastic fundamentals and the minute the bank starts to cut rates they will sell that currency. It’s a lingering perverse logic driven by the carry trade.”
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The Bears Bite Back
With the summer reporting season now upon us, those looking for some relief amidst the bearish gloom are likely to be disappointed. Whilst pharmaceutical stocks like AstraZeneca staged a recovery last week, other traditional defensives like BT have been punished after reporting a lower than expected rise in first quarter earnings. Expect trading to be extra light once the Olympics start.
Several asset managers who have traded through previous bear markets have pointed out that the race to the bottom has been much quicker this time around, possibly due to the sizeable participation of hedge funds. “The market fell out of bed at the start of June and over a six-week period we had a precipitous fall in share prices,” says Alan McIntosh, CIO of Cheviot Asset Management. “In past bear markets it has tended to take several months for share prices to fall so far, but the market reacted very quickly and has already priced in a deep economic downturn.” Because of this, McIntosh believes the current bear market may be one of the shorter-lived ones. “Bear markets tend to run for about 12 to 15 months, so it may run another three to six months.”
Adam Steiner, head of research for public equities at SVG Capital, believes that active trading by hedge funds is partly behind the accelerated share price fall. He points out that global hedge fund assets under management have increased from under US$200 billon in 1995 to over $1.8 trillion in 2008. As a result, over the last decade the average holding period of FTSE 350 stocks has collapsed. “In the mid-1990s it was about two years whereas now it is down to five or six months,” he says. “In mainland Europe the fall isn’t as pronounced due to large bank and family stake-holdings, but it is still down from about 18 months to 10 months.”
Know your rights
The rise of hedge funds has also created a conflict between financial markets and the real economy. “Until this bear market we never had a significant number of people who make money if a company goes bust,” he says. This has been reflected in the recent rights issues by the banks, where HBOS only managed to attract an 8% take-up because its share price was driven below the rights issue offer price.
Regulators have responded with a temporary ban on naked short selling in the US, and the disclosure of trading in rights issues in the UK market. “But the reason why the banks are trading below their rights issue price is more to do with the fact that they are in trouble, and people think that there will be further fund-raising,” says Steiner.
He points out that once, no one would have benefited from a rights issue failing so there was pressure for them to go ahead. Investment banks can make a lot of money from rights issues and they allow struggling companies to continue trading. But now hedge funds can express a view that a rights issue is priced incorrectly, and they will make money if that view is borne out. “Hedge funds remove muddled thinking from the market – they take prices very quickly to what people think they should be,” says Steiner. “That removes the ability of markets to muddle through, and muddling through can be quite useful at times.”
Steiner believes the pending UK recession could be as bad as that of the 1990s, and possibly that of the 1970s, but for totally different reasons. “The basic problem is that central banks have spent the last 15 years trying to iron out the economic cycle, and their focus has shifted from controlling inflation to steady growth,” he says. “In the US, whenever there was the slightest hint of a normal slowdown, Greenspan tended to throw money out of helicopters as fast as he could.”
This approach has led to a 15-year accumulation of poison in the system, which needs to be sweated out. “Unfortunately the banks are realising they have a problem at the same time as companies are at peak profit margins. So we would expect corporate earnings to come down even if nothing else was happening.”
Across the market, equities are now trading at comparable levels to the trough of the 1990-1992 recession. “The FTSE is trading at P/Es of 10.5x, against a trough of 10.4x in 1991, whilst bank stocks are at 5.4x, compared with a long-term sector average of 12x,” says Richard Moore, manager of the Santander UK Growth Fund.
A short squeeze
Ironically, financials have become so over-sold that they staged a rally in July, and are up a modest 1.73 percent over the past month. Peter Lucas, global strategist at Ashburton, attributes this bounce to a period of short covering rather than any change in the fundamentals, and Steiner remains wary: “The UK banks still haven’t taken any write-offs relating to the domestic economy [although the likes of HBOS have increased their provisions to cover bad debt], and our view is that there is no point investing in contentious sectors as the rest of the market is so cheap.”
McIntosh is also cautious about the bank bounce: “It is probably a bit risky to load up with those yet because we haven’t heard all the write-offs, and if a recession occurs then all the bad debts will start to come through.” But he adds that some banks haven’t been caught out by sub-prime and will be able to take market share from the weaklings.
Other sectors being given a wide berth by managers include companies that are vulnerable to higher input costs, such as food manufacturers, and consumer businesses that are operationally leveraged. “The impact of slower sales will be magnified by competitive pricing and rising input costs,” says Colin McLean, manager of the SVM UK Active Fund. “A feature of a number of consumer companies is higher balance sheet debt.”
He points out that buy-backs and stock tenders in recent years, combined with high levels of dividend distribution, have meant that many consumer businesses will enter the slowdown with a weaker balance sheet. This will trigger dividend cuts and force some companies to renegotiate banking covenants – something that appears likely to occur with some UK house-builders. McLean expects weak trading to combine with margin pressures and balance sheet problems to trigger further share price falls in many UK consumer businesses.
In such an environment, Steiner says SVG is looking for companies that aren’t reliant on the cycle to generate profits, and are on an attractive valuation, with no major structural problems. As a result, he likes pharmaceuticals, telecoms and non-cyclical industrials, but is frustrated by the sell-side analysis of telecoms, which he believes has made a wrong call on every major development since the dotcom blow up. “It seems like they got so burned by the TMT bubble that now they always assume the most negative outcome of any story affecting the sector. So telecoms, which should be a defensive, hasn’t been from a share price perspective, even though the quality of the management in UK telecoms is the best by a mile.”
Good hunting grounds
Steiner also believes that small caps have been unfairly written off because of the widespread perception that they do poorly in bear markets as liquidity dries up. “But between 1970 and 1979, small caps outperformed the FTSE All-Share by about 200 percent. Our view is therefore to buy small caps because they have fallen the most.” This means looking for individual stories because small caps are vulnerable to banks pulling their funding or changing the terms of their financing.
Another good hunting ground during a downturn is where private equity deals have failed to come to fruition, as companies wise up to their real value. “We are seeing more talks that don’t go anywhere, where one side is looking for a bargain and the other is looking for fair value,” he says. If the private equity house walks away because it found something in due diligence that it didn’t like, Steiner says SVG will steer clear. “But if the private equity firm walked away because the company’s managers are holding out for a good price, then it could be worth looking at.”
As traders and asset managers head for warmer climes and market volumes thin, a major sell off in miners and energy cannot be far away. July’s fall in the oil place has ensured that commodity-related shares have already taken something of a beating – and given that the resources sector has been the FTSE’s life support for the last six months, this is likely to prove fatal.
“The problem is that there is very poor breadth in the market with a concentration in resources and mining stocks – only a few shares have participated in the upside and we need to see that broaden out,” says Lucas. “But over the last few months, even though the oil price has been going up, oil-related shares haven’t followed it. I think the reason for that is people did not believe that the oil price was sustainable at those levels.”
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Latin Lessons
Receiving investment grade status is supposed to make you more attractive to investors, not less. But over the last few weeks institutional investors have been reducing their exposure to Brazil, with the Latin American indices giving up all their gains since the start of the year.
Patrice Lemonnier, head of emerging markets at CAAM, believes the sell off is linked to general risk aversion and inflationary concerns: “Flows are drying up everywhere in emerging markets – the environment is not too good for equities.” He points out that Asian valuations have halved over the last six months so their overvaluation problems have disappeared, whereas the valuations for Latin America have come off a bit but relative to developed markets they are still the same.
Will Landers, who manages BlackRock’s family of Latin American equity funds, believes profit-taking may also have something to do with it. “There was a very short sharp move upwards following the investment grade rating from S&P at the end of April, and as people were looking to raise cash they decided to take advantage of this. If you’ve been invested in Latin America for a while this is definitely an area where you would have had profits to realise.”
Inflationary pressures
Medium term, he believes investment grade status will help attract more conservative institutional investors to the region, but right now, inflationary pressures are making the region less appealing. “We do see a weakening in bank lending, and possibly some increase in non-performing loans, and as interest rates increase some of the real estate opportunities look less attractive,” says Stephen McCarthy, senior portfolio manager for emerging markets at SSgA.
He believes that Brazil’s central bank has been the most successful in signalling to the market that it will keep inflation down, but many countries have begun to tighten, including Mexico, Peru and Colombia. “Chile is lagging a bit behind the curve but it has been trying to offset the inflows of currency from the very strong copper price,” he says.
Indeed, many of these markets have benefited from strong commodity prices. Mexico has enjoyed a windfall as the price for Mexican crude is twice the amount it budgeted for. “Both Brazil and Mexico have programmes to promote infrastructure investment so ports and the transportation of goods and services should improve,” says McCarthy. “In the long run this should reduce inflation as this will lower the costs of production and make their goods more competitive.”
SSgA views Chinese demand for commodities as a long-term trend despite the fear of short-term pull-backs. McCarthy also doesn’t see the same huge systemic risks of the 1990s, as the LatAm economies are more integrated into global trading networks and fiscal and monetary policies have improved, with the exception of Argentina. “Rising inflation is a concern and loan growth to some of the lower income groups is excessive – there could be some set-backs there. But there is less risk of a foreign exchange crisis than in the past,” he says.
However, this remains a very narrow market, with the same stocks appearing in managers’ top 10 holdings again and again. Everybody loves Petrobras, CVRD (Vale), Banco Bradesco, and America Movil. Hexam Capital’s Bryan Collings, a global emerging markets manager, says he recently bought some of the latter, which he sees as a well-run, safe cash flow generator in the mobile space.
“It is not as exciting as some of the other mobile operators in India, Russia or Nigeria, but as the money comes into Latin America, this will be a beneficiary,” he says. “And it is probably one of the safest, most predictable earnings defensive plays, as so much of Mexico is dependent on what happens in the US, particularly the growth of the southern states.”
Don’t cry – there’s always Tenaris
Argentine pipe manufacturer Tenaris also turns up regularly, liked because it is a global player in the oil services segment, deriving few of its revenues from its troubled home market. Lemonnier says that it remains difficult to get access to markets like Colombia, whilst Chile is expensive due to the participation of local pension funds. Meanwhile Venezuela has disappeared from the investable map following a series of nationalisations – most recently those of its cement and steel industries.
“Latin America is basically Brazil and a handful of other stocks,” says Collings. “Of all the regions it is the smallest and it is shrinking in many ways, in contrast to EMEA where you’ve got other markets coming through. I don’t really think it’s necessary to have a Latin America fund – you can pick the eyes out of it and get exposure to other stocks elsewhere in the world.”
Currently he prefers China, arguing that investors have missed opportunities by not being there. “People think that China has completely blown itself up. But if you look at it, it is only down 13 percent relative to the emerging market index this year, and the banking sector is up some 17 percent.”
He says that Bank of China is up 11 percent and China Construction Bank is up 12 percent relative to emerging markets, so these stocks are doing as well as, if not better than, Brazilian banking stocks. “In fact they have outperformed, year to date, one of the best iron ore producers in the world – CVRD.”
Disappearing act
Collings argues that investors need to dig a bit deeper and look for the inconsistencies in what people are saying: “There is no better example than the amazing Houdini-like disappearance of those people who last year said that when the China A-share market falls, which it has done massively, the China story and the commodities story will be badly affected. Well that just hasn’t happened, has it? But where are these people?”
He argues that the reason why both have been unaffected is because the size of the equity market in China is so small relative to the economy: “It wouldn’t make a difference if it fell 90 percent, in contrast to the size of the equity markets in developed economies, where it does affect your wealth. The Chinese still have well over a trillion dollars sitting in retail bank deposits.”
Collings believes that Brazil’s investment grade status overestimates its capacity for growth, and fails to take into account potentially negative surprises for investors. “Brazil is simply not as robust as people think, not as robust as emerging market funds’ positioning suggests and certainly not as robust as in recent years.”
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A Frontier Too Far?
The African markets are still considered a frontier too far for many, but over the last 12 months a number of managers have entered the space, on the back of roaring commodity prices and capital inflows from China and India.
“There are 200 corporates in Africa but these are under-researched opportunities,” says Stuart Culverhouse, chief economist at Exotix, a securities dealer in frontier markets. “Some markets have had reasonably good runs like Kenya and Ghana, and Zambia’s index doubled last year. Nigeria has also had three years of relatively good growth. But new funds are being set up to invest in this area every week, which helps explain why the performance has been so good.”
Mark Mobius, manager of the Templeton Emerging Markets Investment Trust, is cautious about many of the Sub-Saharan African markets, but is upbeat about their future prospects. “The growth potential in Sub-Saharan Africa is very great so we will be doing more there as we go forward, but it is going to take time,” he says. He warns that within each market there is an incredible variation in valuation and liquidity, whilst in many cases local investors still dominate.
Infrastructure push
Despite a mixed political backdrop, he sees Nigeria, Kenya and Ghana as amongst the most interesting markets. “Kenya has a pretty good history of capital market development, but we’ll have to live with political problems for a while in this region. The good news is that it is attracting a lot more investment than it has before, particularly with the Chinese, Russians and Indians moving in. And whenever you have that kind of push, you start to get infrastructure working.”
But he adds that markets like Namibia are still too small to be of interest: “When I first went there, the stock exchange was in a shopping centre,” he recalls. “And when I first went to Botswana, I walked into a broker’s office and said: ‘Where’s the stock exchange?’ And he said: ‘Turn around, you’re in it!’ I turned around and there was a list of stocks. This is the kind if thing you have.”
By contrast, Nigeria has attracted a lot of the initial interest from foreign investors because of a healthier financial sector. “Banking and insurance reforms are encouraging institutional domestic investment in Nigeria,” says Culverhouse. “The market has been led up by banks, but 8 percent non-oil GDP growth is helping the stock-market.”
Stephane Bwakira, manager of the Standard Africa Equity Fund, which invests across the continent and now has some $330 million under management, says that the recapitalisation programme in Nigeria has led to a lot of consolidation, with the number of banks in Nigeria falling from 89 to 23. “Most of them now have at least $1 billion in capital which has made them stronger and able to take on big transactions in the oil and gas sector, and the big infrastructure projects,” he says. “Historically these have gone to foreign investment banks, but the local content requirement has helped.” This says that a percentage of any business undertaken by the big conglomerates must be transacted through the local banks.
Credit expansion
The banks have also ramped up their businesses following debt write-downs, and are now taking on real risk. “The banks are competing for the same corporate business so their margins are thinning out, and therefore they are now starting to lend to retail customers,” explains Bwakira. “We are seeing mortgages, car loans and credit cards creep up. There are still some legal issues to be sorted out but the banks are expanding their footprints by opening more branches to get more clients onto their books.”
He adds that it is a similar picture in Morocco for mortgage lending, and property developers are seeing a big increase in business due to government-sponsored low income housing programmes which offer developers tax incentives. Meanwhile, the growth of housing in Egypt for the young professional classes is also supporting the expansion of real estate and mortgage lending.
Bwakira’s fund is not untypical in spreading its net wide, including stocks listed on other exchanges that transact the majority of their business in Africa, as well as MNCs with local listings. Despite the high risk associated with these small, illiquid markets, Bwakira argues that diversification across the continent offers a natural hedge. This means that when Kenya experienced violence following the disputed election earlier this year, this had no ripple effect on Zambia, and a positive effect on Mauritius, which inherited some of the tourists that might otherwise have gone to Kenya: “There is very little correlation between markets and currencies.”
He too is upbeat about the future for this region: “We have seen a lot of interest and flows, whereas three years ago it was very difficult to get anyone to even look at it, but the perception is quite different now. Africa is the last frontier market, but people are buying the long-term growth story.”
If you want to read more about how managers are tapping African investment opportunities, please visit:
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No Way Out
Comedian Rob Newman used to do a routine about the world’s dwindling supplies of oil, the essentially doomed nature of the petrochemical economy, and the increasingly desperate attempts governments and oil companies would employ to keep the lights on. But whichever way they turned, however hard they tried to escape from the inevitable, eventually they would have to face up to the fact that there was no way out – fossil fuels would run dry. In the routine, this sobering fact was epitomised by a cackling Baron Samedi figure in a gloomy stairwell.
It is still possible to find people who cite the supply argument in favour of a decline in the oil price – perhaps they’re banking on those Canadian tar sands coming up trumps. Others argue that even if a recession reduces demand in the West, any fall in price is likely to be modest and short-lived, as India and China keep industrialising.
The historical oil consumption per capita charts certainly make for grim reading. Whilst India and China are still at the usage level of the US in 1904, the experiences of Japan and South Korea are instructive. The charts show that whilst consumption is low in the early years of industrialisation, the following decades see a sudden exponential increase per capita. For Japan it happened in the 1960s, for South Korea, in the 1990s. It will be interesting to see how such a spike in usage by China and India will affect the market for oil in the next 20 years.
Energy crisis
Newton Investment Management, for one, is worried. In a recent research note it commented: “Unlike previous oil price spikes, there appear now to be few options to ‘get out of jail free’. We are witnessing not simply an ‘oil problem’, but rather the first stages of what could become a global energy crisis. The challenge now is the dearth of inexpensive, available energy sources to permit the reduction of oil demand through fuel switching.”
Ah yes, if only we had started investing in alternative energy back in the 1980s, then perhaps we wouldn’t be in this fix. Unfortunately, election cycles are too short to incentivise governments to take the tough decisions that are necessary to deal with such issues. And the longer we delay, the more expensive the bill when it finally falls due – which discourages subsequent governments from making themselves unpopular by stepping up investment.
“Failing to take tough decisions will lead to an extended period of energy inflation,” warned Newton. “This will prevent OECD economies from stimulating growth through monetary policy, while developing economies, burdened with subsidies, will be forced into trade controls and commodity hoarding.”
It suggested that governments should consider adopting mandatory investment in hydrogen networks, carbon sequestration and the development of second generation bio-fuels that do not compete with the food chain: “The real cost and impact of energy prices must be tackled, or the lights really will start to go out.”
Unfortunately, such Cassandra-like cries are rarely welcomed. Demand will fall in the West, the oil bears insist, and supply will start to come through, then the oil price will tumble. The bulls respond that once the industrialisation genie is out of the bottle, it can be hard to stuff it back in again.
Although most analysts have tended to be behind the curve in predicting the oil price, insisting that it must come down because that’s how it behaved in previous cycles – you remember, when the two most populous nations in the world weren’t industrialising – Global Insight recently revised its forecasts. It now believes that oil, food and raw materials costs will keep rising throughout the first half of 2009, and expects the price of West Texas Intermediate crude oil to peak at $160 a barrel in December 2008, up from $124 in its previous forecast.
“Growth in both real GDP and energy demand in emerging markets is likely to remain strong for some time,” said Nariman Behravesh, Global Insight’s chief economist, and Sara Johnson, economist, in a forecast alert. They pointed to a combination of stimulative monetary policies and fuel subsidies, which weaken the incentive to conserve energy.
“While some countries are beginning to tighten monetary policy and some are cutting fuel subsidies, these moves have been modest and are unlikely to have any significant impact until late 2009 or 2010,” they said. “In the meantime, strong energy demand growth in emerging markets will outstrip additions to non-OPEC supply and will offset the declines in demand that have already occurred in the US and Europe.”
Fuel subsidies
The question now is how long non-oil producing nations can afford to maintain fuel subsidies. India is already facing a ballooning fiscal deficit, but Vinay Gairola, manager of the Atlantis India Opportunities Fund, doesn’t see fuel subsidies being ditched in an election year. “There are 500 million poor voters who won’t allow this subsidy to be cut – the government doesn’t dare tinker with this,” he said. Instead, he sees the possibility of a windfall tax on Reliance Industries and Cairn Energy to help plug the gap. And Tata’s plans for an affordable runabout are likely to keep oil demand ticking along for a while yet.
Meanwhile, countries like Russia and the Middle East are simply using the receipts from their oil revenues to fund domestic fuel subsidies. Newton points out that in previous crises, natural gas has taken up the slack, but recently liquefied natural gas prices have risen faster than crude prices. “In the Middle East, a shortage of natural gas is having a direct impact on the oil supply: first because oil products are being burned instead of natural gas, and secondly, because reduced gas injection into oil reservoirs is curbing the production of crude oil.”
But isn’t it just the activities of those naughty speculators that have pushed up the price, say the oil bears. Well, Newton believes that the rise in price to $135 per barrel in May owed much to capitulation by commercial buyers, such as airlines, who had been waiting for the price to fall – as had been forecast by most commodity specialists in light of an impending slowdown in global economic activity: “Even the bullish, and widely-followed Goldman Sachs commodity team suggested a near-term correction in the oil price.”
Buying the curve
So when Goldman Sachs increased its forecast for the end of 2008 oil price from $115 to $149 a barrel, commercial buyers scrambled to ‘buy the curve’. “The rise in the oil price was exaggerated by the actions of hedge funds, which as the true speculative buyers, reversed the time spreads, which had entailed their betting on the short end of the curve, against the long end,” said Newton.
Even if the oil price does eventually roll back, it is likely to do so to a price well above previous plateaus. Global Insight is now predicting a fall in the oil price by the end of 2009, to $130, compared with $111 in its prior forecast, and to $105 by the end of 2010. But it warned that geopolitical events, such as conflict between Israel and Iran and more supply disruptions by rebels in Nigeria, could easily push prices higher.
If you want to read more about oil demand and supply dynamics and how the oil price is impacting earnings at energy companies, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=3&storycode=43565
Tapping the infrastructure boom
With billions of dollars of spending slated for new infrastructure in emerging markets over the next decade, investment managers are keen to take a slice of the cake. For example, Russia has pegged $185 billion for pipelines and ports to facilitate the export of commodities. The CEE is looking to spend $25 billion on a trans-European road and rail network, and Brazil has allocated some $100 billion across a range of sectors to support telecoms, engineering and construction, and transportation. But tapping this opportunity is far from straightforward.
Philippe Guigny, senior emerging markets manager at CAAM, which has just launched an Indian infrastructure equity fund, says that infrastructure investment is now a key theme for governments. “In resource-rich countries we are always looking at those sectors anyway because these are the drivers of growth for emerging markets and underpin natural resource exports. Asia, Eastern Europe and Latin America are all taking measures to enhance their infrastructure but we think there is more potential in Asia as the population is so much bigger.”
China and India in particular have already attracted a lot of interest, but direct investment in this space is not for the novice. Trusted Sources, an independent research firm, has recently published two reports in collaboration with consultancy Urandaline, to examine the impact and the scope for investment, of infrastructure modernisation in China and India.
“India is more interesting for investors because you can go direct or there a large number of companies available, from cement companies, such as Ambuja Cement and ACC, to manufacturers of railway rolling stock such as Siemens India,” says Lawrence Brainard, chief economist at Trusted Sources. He points out that India is way behind in its infrastructure spending, and therefore has a political imperative to address it. “They also need to draw on the private sector in a way that the Chinese don’t.”
Patience required
Almost US$500 billion is budgeted for infrastructure spending in India’s 5-Year Plan budget to 2012, and one third of this is expected to come from private firms. But Brainard warned that this would test the country’s political flexibility and the patience of potential investors.
“For direct investors the most important judgement is the political judgement. Power is one of the most politicised sectors in India, so there are tariff controls. As an investor this means this is only a good opportunity if you are able to manage the political risk.” And only a handful of Indian companies have the political contacts to get things done, he believes.
Most private direct investment has to be done in the form of a Public Private Partnership (PPP), and therefore adequate legal documentation and the choice of partner is crucial. “As a foreign investor, you will be in a partnership with a state or federal entity so it’s critical that you think about how those interests are balanced,” he says.
“With the railways, which is a huge monolithic industry, you would also want a big local partner with clout. You need to think about the leverage of the local parties.” Indian Railways, which owns a lot of the prime real estate in cities, has failed to develop its sites due to internal feuding, with a plan to build budget motels at terminals becoming bogged down by bureaucracy and infighting.
The port sector is less politicised, with the minor ports competing with each other to attract investment, and 30-year licences on offer to private operators: “So one of the best opportunities for direct investors is to go into one of these developments,” says Brainard. But he adds that it is essential that the state government commits to connectivity – that is, ensuring there is the road and rail access to get the freight out.
“The problem is that the notion of Indian infrastructure is so sexy now, there is more money than projects, which has pushed down the rates of return. There are too few good projects.” He says that with something like the metrorail projects, which are being done on a PPP basis, there is strong competition because this is viewed as a long-term opportunity – the winning groups hope to use it as base from which to expand.
Jonathan Fenby, director of China research at Trusted Sources, says it is a similar story for China, where sub-contractors will be needed for huge projects. “The emphasis at the moment is on getting foreign investors into sectors where the Chinese lack the technical know-how,” he explains. “They are now trying to move up the value chain because places like Vietnam and Bangladesh can undercut them on cheap labour.”
Sectors of particular interest include railways, energy, seaports and inland waterways, and water and waste management, as these lag behind what is required both to meet consumer demand and to keep industry moving forward. However, Fenby warns that political constraints are evident as powerful interest groups seek to protect their turf.
Coal by wire
For example, Chinese railways are very inefficient with lots of stopping services and single tracks. This has made it difficult to convey coal from the coalfields in the north to the booming coastal cities. “China is currently a net importer of coal because it has been quicker and easier to import coal from overseas than to bring it through the interior,” said Fenby. “This has led to a move to build power stations at the coal mines with the aim of transmitting the electricity over long distances to where it is needed – what they call ‘coal by wire’. But that needs a massive improvement in the electricity grid and there is no Energy Ministry.” A proposal to set one up was opposed by the big power generators.
Similarly, a proposal at the National People’s Congress in March to set up a central transport ministry will not include the railways due to powerful vested interests within the Ministry of Railways. Fenby believes that the ambitious network expansion plans unveiled by the Ministry of Railways will be insufficient to meet the demand from passenger and freight that is envisaged over the coming decades, but suppliers of signalling equipment, rolling stock, sleepers, and steel might be worth a look.
Bureaucratic wrangling is also accentuating a water crisis in China, with approximately a dozen ministries and government departments involved in water policy. On a positive note, the sea ports were deregulated and decentralised 15 years ago and foreign investors have gone in. “The question now is whether this can be applied to inland waterways, as Central and Western China could be opened up by making the Yangtze River a modern transport hub,” Fenby says.
If you want to read more about the opportunities in infrastructure investment in both emerging and developed markets, please visit:
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Infrastructure becomes electric
Not so very long ago, infrastructure investment was a sleepy little backwater populated predominantly by Canadian pension funds and Australian banks. Considered too arcane for mainstream investors, and a lot less interesting than those exciting whiz-bang mortgage-backed securities, the infrastructure specialists were left to their own devices.
A few years ago this all started to change as European asset managers woke up to the opportunities provided by the privatisations of old state assets in Eastern Europe and the redevelopment of ageing infrastructure in the West. This year the story is all about infrastructure needs in emerging markets – and following the implosion of the credit derivatives market, real assets suddenly look a lot more appealing.
Christophe Nagy, manager of Edmond de Rothschild Asset Management’s new
Infrasphere fund, sees infrastructure as a defensive investment, which benefits from long-term relatively visible trends in both emerging and developed countries. “These companies may also have guaranteed returns on assets or index-linked tariffs, and that’s a significant advantage in the current environment as inflation becomes more of a concern,” he says.
Returns squeeze
Infrastructure is said to have performed well in the 1970s against a backdrop of stagflation, and with the big US pension funds such as CalPERS and CalSTRS planning allocations, the flows are expected to keep on coming. But this rise in interest has begun to squeeze returns at the top end of the direct market, as the stiffer competition is making it harder for the biggest funds to secure the high returns of yesteryear. Whereas $2-3 billion was once considered a sizeable fund, the largest direct funds are now weighing in at $7-8 billion, forcing teams to scour the globe and bid aggressively for deals in auctions.
Steve Jacobs, global head of infrastructure asset management (IAM) at UBS, believes that these mega funds may not get invested very quickly as they are forced to focus on the biggest, headline deals, and there aren’t that many of them out there. “We want a meaningful but manageable-sized fund that we can get invested quickly,” he says. “In our core fund we are targeting OECD investments because we want to mitigate the regulatory, legal and economic risks and OECD countries have transparency over the economy and a proven rule of law.”
The most recent investment is a 28 percent stake in Saubermacher Dienstleistungs, an Austrian waste management company. UBS’s stake will produce an IRR of over 15 percent, and allows UBS to take an active role in developing the business. Vincent Gilles, head of infrastructure AM, EMEA at UBS, sees strong growth opportunities for Saubermacher as Central Europe is binning more, so the company will benefit from the EU directive to treat more waste by 2012.
“People will increasingly have to pay to get rid of their rubbish, and you can make money out of recycling the components of some household appliances,” he says. “Saubermacher has a refuse derived fuel strategy to take advantage of this – for example, when oil is over $80 a barrel it’s economic to make fuel by burning plastic bags.” Gilles sees the best opportunities in mid-sized cities in Eastern Europe: “There is no point going up against the big French companies when it comes to auctions in the major cities.”
Around UBS’s core fund it is planning a number of satellite, regionally-focused funds, of about US$500 million in size. As well as a MENA fund, coming in September, Jacobs says UBS is bullish on China and Latin America, but it won’t do ‘me too’ funds.
UBS already controls a full-service domestic bank in China, so is aiming to launch a direct infrastructure fund in 2009, with a sector bias. “We will look to take a quality operational local partner and we will offer something quite different from the rest of the marketplace,” Jacobs promises.
UBS also has an interest in a large Brazilian bank, which invests in infrastructure, and is hoping to leverage this towards the back end of 2009. “There is a lot of demand for Latin America due to the commodity-driven boom. We’ll be focused on green-field sites,” says Jacobs.
Style drift
But it is not just direct investment that has taken off in the last 12 months. A raft of infrastructure equity investment funds have also launched – not surprising perhaps, as direct investment requires a significant amount of industry expertise and the ability to manage operational risk. But Jacobs believes that such funds are at the risk of style drift: “Either they don’t have the experienced teams or they lack the deal flow, so you get funds investing in shipping, airlines or lotteries – that might be allied to infrastructure, but they don’t pass the simple test of an economic downturn.”
Christophe Nagy’s fund is strictly infrastructure, and focused on industries that are relatively uncoupled from the business cycle; operating natural monopolies; or in sectors that are highly regulated, such as infrastructure management, production or concessions. The maintenance and construction businesses, which are subject to greater variation in their orders, or shorter contracts, are excluded.
Nagy tries to strike a balance between electricity, transport, and water and gas, to offset interest rate effects and the commodity impact. “Water, gas, and waste management are stable but also subject to movements in long term interest rates,” he explains. “But transportation, which is very cyclical, performs well when rates go up. Adding the two together hedges the interest rate sensitivity and mitigates commodity exposure.”
He is currently keen on the transmission theme in the US, warning that it needs to ramp up its investment or face the prospect of power shortages in many areas: “By 2015 it could be very serious. They need to reinvest, but depending on the state, there are different regulations and you have to be very careful at picking the right states.”
Check the contract
A real understanding of the regulations and drivers in each market is crucial, especially as contracts can vary. Jacobs warns that wind farms can be over-priced in America but offer value in Europe. “Gas storage is the same – in Europe you can get long-term contracts but in America they might only run for two or three years, so it is less of an infrastructure play.”
Philippe Guigny, senior emerging markets manager, CAAM, which has just launched an Indian infrastructure equity fund, says that investors also need to think hard about the portfolio mix, as some investments, like energy, deliver more quickly than others. “Valuations need to be looked at on a stock specific basis as expectations are sometimes too high and may not be realised. Investors should also scrutinise the types of contract that companies are securing.”
Some companies work on a cost-plus basis so that they are not exposed to rises in input prices – this means that whoever has commissioned the project agrees to bear any increase in the cost of materials and energy. Conversely, some Indian and Korean companies working on infrastructure projects in the Middle East have seen their margins squeezed as energy and materials prices have risen.
He is also wary about some of the new Chinese railway stocks that have attracted attention, such as China Railway Group, China Railway Construction and China Communications Corp. “The Chinese have long term plans for their railways but these stocks are relatively expensive,” he says. He prefers the electricity generating companies in Brazil, and Asian companies which are benefiting from the construction boom in the Middle East, such Korean desalination stocks.
Nagy adds that you can still pay a premium for the visibility on earnings of the developed market companies. “But surprisingly you can buy Chinese highway stocks at 15x earnings, which is cheaper than those in Europe, and they will grow at 15-20 percent earnings. So on a P/E to growth basis these are much cheaper than their European counterparts.” He suggests that this may be because there is still some reluctance from investors to go into this area. “But they are listed in Hong Kong so they have visible earnings, and it is high quality infrastructure.”
If you want to read more about the opportunities in infrastructure investment, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=42936
Into The Woods
July 11, 2008 at 1:08 pm (Macroeconomic commentary, UK equity markets) (banks, Bear market, Commodities, energy, financials, Japan equities, mining, monolines, UK equities)
Careful there! Tread quietly! We are now in official bear territory. Who knows what dangers lurk in these woods?
Yes, the FTSE finally succumbed to the inevitable and crashed through the technical bear barrier this week, following the S&P 500’s ignominious tumble into the badlands earlier this month. On Tuesday the FTSE All-Share fell 20% off its October high of 3,467, whilst this morning the FTSE 100 ventured into bear territory by crashing to 5,333.9, well below the 5,385 bear threshold.
“The news that we have officially entered a bear market comes as no surprise to many investors whose shareholdings have halved in value,” said Angus Campbell, head of sales at Capital Spreads, on Tuesday. “The 20% rule simply confirms what we have long suspected since the beginning of the year – we are well and truly in the grip of a grizzly bear market.”
Manoj Ladwa, a senior trader from TradIndex, said that financial stocks, including RBS and HBOS, had fallen further in response to losses in New York, while house-builders had had another bad morning following a predictably weak trading update from Persimmon. “Mining stocks, which have been a mainstay of the index this year, started to weaken, as analysts lose faith in BHP Billiton’s takeover of Rio Tinto happening any time soon.”
Danger – loose bears
Campbell said that it is a clear danger signal when there is a 100 point rally in a market that is trending lower, followed by a large sell-off to test new lows. “That is exactly what we have seen [this week] with financial stocks yet again leading the way. The outlook for pretty much every stock though is truly dire at the moment and if it was not for the energy and mining sectors keeping us afloat, we would have been testing the 5,000 level months ago.”
He added that if investors now pull out of the energy and mining sectors, it is anyone’s guess where global indices will bottom out. The FTSE 100 currently contains 10 mining companies, and seven oil and gas companies. By market cap, there are four mining, and three oil and gas stocks in the top 10 alone, and these companies collectively account for 50% of the FTSE 100’s total market cap. This is creating some concern amongst the trackers, which are now heavily exposed to what tend to be very cyclical industries.
Meanwhile, the outlook for financials worsens day by day. As the economy grinds to a halt, credit defaults are finally starting to come through, threatening to turn what was a liquidity crisis into a solvency crisis – witness Bradford & Bingley’s increasingly desperate attempts to raise cash. All those blank cheques written by merry banks in the consumer spending boom are now falling due. The UK banks are staring into a black hole of buy-to-let mortgages and worthless credit card debt.
This is reflected starkly by the sector’s performance since the credit crunch began. According to Bert Veldman, senior investment manager, global equity, at ING Investment Management, share prices of financials have dropped by an average of 43 percent since the peak in April 2007. And in the second quarter, global financial equities fell by an average of 12 percent.
Eaten by bears
House-builders are also feeling the pinch, with Capital Economics now predicting a 15 percent fall in UK house prices this year, and a fall of 35 percent over three years. Not surprisingly, house-builders have received a thorough mauling by the bears and are desperately trying to raise capital.
Back at sub-prime’s ground zero, the investment banks are still announcing new write-downs following the long-anticipated monolines downgrades last month. After many warnings, Moody’s finally downgraded Ambac and MBIA – the former by three notches and the latter by five notches. S&P had already downgraded both, suggesting that we will see further fire sales by those investors and conduits who can only hold Triple A-rated securities. Investment banks must also increase their risk-weighted capital to offset these downgrades.
For example, Merrill Lynch holds some $18 billion in collateralised debt obligations and asset-backed securities, of which the majority is insured via monolines. Now that these insurers have been downgraded, the risk for Merrill Lynch has increased. The worry is that this will lead to fresh, substantial write-offs and that banks will be forced to liquidate positions, says Caspar van Grafhorst, head of investment grade credits at ING Investment Management. The market is expecting Merrill to write off about $5 billion for the second quarter.
But Guy de Blonay, manager of the New Star Global Financials Fund, says that the key issue for investment banks is not necessarily whether more write-downs will be revealed but whether they can write new business over the next few years. “There has been a fundamental shift in institutions’ desire to embrace risk. Some profitable business lines may, therefore, be closed for months and perhaps years,” he says.
The worsening economic outlook does not rule out the possibility of bear market rallies, however, and this morning the FTSE 100 obliged with a rebound. This followed reports that the US government was mulling a bail out of its hapless Fannie Mae and Freddie Mac mortgage agencies, which Lehman says will have to write off another $75 billion.
This rally was short-lived, however, as the market then charged headlong into bear territory, perhaps after realising that the fundamentals in the UK hadn’t changed. The question now is whether the combined strength of energy and miners will be able to prevent the FTSE falling further. State Street’s latest fund flows note reported that institutional investors are becoming increasingly sceptical about the commodities boom, with selling already underway in the materials sector.
Bear traps
Joost van Leenders of Fortis Investments points out that bear markets usually end with a final sharp fall as the last bulls capitulate. The average decline during bear markets after recessions is 28 percent, but this includes some very large drops, such as the 50 percent fall after 2001. “These large drops started with overvalued equity markets, which was not the case this time,” he adds. However, earnings have been high, and have only just fallen back to trend. He also believes that economic and profit forecasts for the second half of 2008 look unrealistically high.
Fortis is now adding to Japanese equities – still leading the field as the least loved market around – followed by US and emerging market equities. “We have not suddenly become Japan optimists but we think that a lot of the bad news is priced in,” Leenders says. Certainly the Japanese economy is looking in better shape than the UK’s for once. And those bulls have got to find somewhere else to chew grass, right?
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