There will be some empty seats in City offices later this month as the Glorious Twelfth marks the start of the grouse-shooting season. Pheasants are as cheap as battery chickens these days but grouse is still a quarry that is highly prized both at the table and by the hunter. The birds are becoming rare, their population ravaged by a tick-carried virus, strongyle worm and two years of heavy rain in their laying season. Even when sighted, a covey can reach speeds of up to 90mph and often elude the most experienced guns.
Not that the gentlemen of the City should be overly concerned if they return from the moors brace-less. Most of you will have bagged handsome prizes already this year. If you didn’t celebrate a gong at Euromoney’s wonderfully debauched Awards for Excellence party (mine was, if yours wasn’t), you will no doubt have been filling your boots with record M&A volumes and primary market issuance.
Secondary markets haven’t been too shabby either, with the Dow Jones Industrial Average at a record high, and bourses from Frankfurt to Mumbai in new areas of the stratosphere. In spite of the still-unfolding slow-motion train crash in the US sub-prime mortgage sector, the China wobble at the end of February and the dramatic spike in yields in the first half of June, institutional investors have continued to seek out risk.
They have been rewarded. The MSCI World Index of developed equity markets is up a handsome 11.49% year-to-date. But even that performance pales beside the MSCI Emerging Market Index, which is up a whopping 24.94% in US dollar terms.
Part of the explanation lies in the underlying strength of the world economy. So far in 2007, the OECD’s Composite of Leading Indicators has risen every month. Liquidity conditions are also bolstering risk appetite. The US dollar falling to fresh lows transmits weaker monetary policy to the rest of the world as central bankers in Asia and commodity-producing currencies intervene to buy dollars in order to stop their currencies appreciating too fast.
| Liquidity - The Brakes are Squeezed |
 |
| Source: State Street |
Nowhere is this more evident than in China. The country’s foreign exchange reserves (mostly dollars) now stand at $1.33 trillion, the world’s largest. In just three months between March and June those reserves grew by an astonishing $131 billion. The soaring price of oil, hovering near record highs of $78 a barrel, will also keep money from the huge sovereign wealth funds in the Gulf and Norway flowing into asset markets.
However, interest rate expectations and policy are simultaneously tightening almost everywhere. These countervailing liquidity trends will test the glass-half-full attitude of investors. Nobody can say with any certainty that the problems in credit are confined to those areas of the markets directly exposed to the debacle in the sub-prime mortgage sector.
But concerns are not confined to the opaque corners of the credit world. Another hint of potential trouble is that the Vix Index of US equity market volatility has remained at elevated levels. Following the early summer swoon in emerging markets last year when the Vix briefly soared above 20, it fell back to its previous trading range in the low double digits. Following the Chinese-induced sell-off on February 27 the volatility index went above 19. However, instead of drifting back to complacent levels it has stayed above 15.
One reason is corporate leverage. Stalked by private equity firms, many CEOs are deciding now is the right time to pile on debt, lest a barbarian at the gate does it first. Over the past four quarters corporate debt issuance in the US has hit $236 billion. In 2005, during the purge of excesses following the bursting of the TMT bubble, the total issuance was just $60 billion.
The decline in volatility seen between 2003 and 2007 might well prove to be a cyclical phenomenon. The debt-to-profits ratio is also rising in the US for the first time since 2002. Investors will demand wider spreads, which in turn points to greater uncertainty about corporate growth. The earnings season has so far met expectations, while falling well short of the double-digit expansion that has become the norm. Winning in markets has been too much akin to shooting fish in a barrel of late. It might well require skill levels more attuned to the grouse moor in the months ahead.