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Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues |
Best in show 2006
Sin Nian Hao. If you do not already know (and clearly an emergency diversity training refresher course is in order if you don’t) this is the Chinese Year of the Dog. What our four-legged friend augurs for markets in 2006 is anyone’s guess. But on the basis that every dog has his day, it is time to buy Malaysian equities. Remarkably, of the 98 equity indices – multi-country, single country, developed, emerging and small cap – published by MSCI, only its Malaysia Index registered a decline in 2005 (of 2%).
That is exceptional, although not in recent years. In 2004 China, Taiwan and Thailand were the only fallers, none by more than 5% and in 2003 not a single MSCI equity index registered a decline. Emerging market equities are up more than 200% from their 2002 lows and emerging market bonds have enjoyed an unprecedented five-year bull-run. The JPMorgan EMBI + index is priced at a slender and historically unprecedented 226 basis points over US treasuries.
Does anyone fancy 50-year UK sovereign risk for 48bp of real return? For those with a taste for the exotic, what about art? The artprice.com index is at levels last seen in 1990 when the Japanese were buying up the Impressionists with the rabid enthusiasm of Dutch tulip bulb traders in the 1630s.
The tide of global liquidity has lifted all assets and it is not just professional worrywarts like retiring Bank of England deputy governor Sir Andrew Large who see price bubbles everywhere. Ben Inker, who oversees $29 billion in asset allocation strategies at Boston-based fund manager GMO (which manages $102 billion in total), says: “It is the toughest time to take on risk in pursuit of good returns that we have seen ever. I include 2000.”
For individuals the best place for cash might be under the mattress. But fund managers are compelled to put money to work and so are in the business of pricing relative, not absolute, risk. For Inker that means emerging market equities is still the asset class to hold. He says: “At 13.5 times earnings you are still getting paid something for risk, not an awful lot, but something. Over five or 10 years I will beat cash by a decent amount. I can’t say the same for US equities, for example. If I sell emerging market equities, anything I buy will have a lower expected return.”
“This time it’s different” are the four most dangerous words in investing, but a comparison between emerging markets now and the last time the Dog was in the ascendant is instructive. That was 1994, the year of the Mexican Tequila Crisis, the first of many swoons in emerging markets that culminated in Russia’s default four years later.
The Tequila Crisis struck when Mexico was running a current account deficit of 7% of GDP. Today Mexico’s deficit is around 1% of GDP. In contrast the US deficit was 6.4% of GDP last year and could easily surpass 7% in 2006. Inflation in Mexico at 2.9% is markedly lower than in the US (3.5% year on year in November) and Mexican interest rates are a full four percentage points higher. This picture of sound economic management is now commonplace in emerging markets.
Jerome Booth, head of research and one of the founders of Ashmore Investment Management, a London-based firm specializing in emerging market debt, has watched the dynamics of his market evolve with more intensity than most. His firm was established, via a management buyout, in March 1999 close to the nadir for the asset class. A prophet is never loved. But after hard years of proselytizing Ashmore has seen its assets more than double since the end of 2003 to $12 billion.
For Booth: “Spreads, history and statistics are an irrelevance. Risk is everywhere. The relevant question is whether sovereign risk is correctly priced.” Emerging markets as a group will become net creditors this year, Russian bonds could trade at narrower spreads than Italian and if Jose Serra wins the election in Brazil the country’s debt could make investment grade.
Indeed, Booth sees just as much risk in developed markets, where investors have stopped differentiating between credits in the eurozone, despite the ECB gently warning last year that bonds with credit ratings at lower than A– would not be accepted as collateral for cash in its repo market operations. Standard & Poor’s rates Italy AA– (negative watch) and Greece A (stable outlook).
For the time being investors are in love with risk and love is blind. “Sooner or later people will get scared again. I don’t know when and I don’t know why, but I have to be vigilant,” says GMO’s Inker. “Will it be in 2006? Perhaps. But I can’t invest with that assumption. At this moment the biggest risk of all is not to hold risky assets.” In the Year of the Dog, emerging markets are likely to win best in show.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
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