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Will Fortune Favour The Brave In This Climate?

Investment Round Table Singapore Business Times 7 November 2008


Moderator: Anthony Rowley, Tokyo correspondent, The Business Times


Jesper Koll, president and chief executive officer, Tantallon Research, Japan

Robert Lloyd George, chairman and CEO of Lloyd George Management, Hong Kong

Ernest Kepper, former official of the International Finance Corporation and Wall Street investment banker heading an Asian financial consultancy

William R Thomson, chairman of Private Capital Ltd, Hong Kong and advisor to Axiom Funds and Finavestment, London

Christopher Wood, managing director and equity strategist, CLSA Asia-Pacific Markets, Hong Kong



FORTUNE is said to favour the brave, but is it bold or foolhardy to venture back yet into bombed-out equity and other financial markets? A panel of investment veterans assembled by The Business Times was of the view, on balance, that now is indeed the time to be venturing back into the markets, although one expert was bearish to the point of suggesting that financial markets could yet be brought to a standstill by confusion over the valuation of assets. There was a consensus too that the worst is by no means over yet for the global macro-economy.

Anthony Rowley: Welcome, gentlemen, to this Investment Roundtable, and it's good to have so many veterans of the investment world back with us at a time like this. The crisis has persisted for more than a year since the sub-prime mortgage problem first surfaced. How much longer could it continue, and how much deeper might it get? Jesper, I know you feel that there's more to come. Tell us why.

Jesper Koll: We are probably past the point of maximum pain in the financial crisis. However, it is far from over. Across all financial economies, leverage will be cut back much further, and this unwind is poised to cause more losses to jobs, to growth and to future returns. So far, global wealth destruction is equivalent to about one year of global GDP. In Japan during the 1990s, the total wealth destruction ended up coming to about 3 times GDP.

Robert Lloyd George: The crisis is not yet over entirely but reflationary supports have been put in place in all major countries and therefore I would not expect it to get much deeper. However, there will still be some shocks, surprises and losses which surface unexpectedly in large institutions.

William Thomson: Japan took about five years from the time it started to recapitalise its banks. Sweden and Thailand took a little less time but neither were V-shaped recoveries. There is a far greater urgency to efforts now in the US and Europe after a year of dithering and denial but these are early days and the scale, being global, is larger and we have the unprecedented scale of the derivative problem.

It could still spiral out of control, requiring the whole banking sector to be taken into public ownership, but more likely we will have an extended period of recession and subnormal growth covering much of the Obama presidency.

Christopher Wood: My view has long been that US-related debt write-offs could easily total US$1.5 trillion eventually. There is also the issue of other regions' vulnerability, such as Europe's own debt excesses.

Rowley: How deeply do you expect the crisis to ramify into the 'real' economy and how long will the overall downturn last?

Mr George: The real economy has already felt the drying up of credit particularly in trade finance and in customer credits. This is very serious and will impact trade volumes. We have seen, for example, the collapse of the Baltic Dry Index, which may be the most immediate and sensitive indicator of this shrinking of global trade. My hope is that the slump in the real economy will not last more than about 9-12 months given all the efforts of the international authorities to support it.

Mr Koll: Money and credit is a leading indicator for growth and, unfortunately, the world has become increasingly dependent on credit and financial engineering. This is not just a US problem; look at China, where last year almost half of the corporate profit growth was due to financial engineering. Overall, the global economy needed about US$5 of credit growth to make US$1 of global income by the end of last year. A decade ago, that ratio was closer to two-to-one.

Everywhere - US, China, Europe - the private sector will wean itself off this credit addiction. The key question is how aggressive public investment and public spending will be to counter this downdraft. The more fiscal spent now, the shorter the recession. And the real winners will be those countries that have great technocrats and long-standing experience of actually implementing public spending projects that actually lay the groundwork for future private sector growth. Asia in general, Japan in particular, looks promising in this respect.

Mr Thomson: In my opinion, we could well be at one of the transition points in economic history. The past 30 years of market liberalisation and deregulation are going to be challenged and called into question in a way unimaginable 2-3 years ago. It is quite possible that US president-elect Barack Obama will be presented with problems akin in magnitude to those Franklin Roosevelt faced in 1933, forcing a major rethink in the way the economy is managed. Old industries, such as automobiles, are on their last legs and looking for government handouts. Millions are facing foreclosure of their homes. The healthcare and pensions crises require addressing and they come at the worst possible time when the financial sector is in meltdown. The whole concept of globalisation, on which prosperity has been based, could face substantial challenges if the US economy in particular deteriorates significantly.

Mr Wood: The present systemic financial problem faced by the Western world poses a severe deflationary risk for the world economy. Recent government policy activism may save Western economies from the sort of V-shaped downturn suffered by Asia 10 years ago. But the cost will be a dramatically longer period of sub-par growth. This will likely mean in the US and the Western world in general a more protracted L-shaped economic growth trajectory.

I do not believe that recent efforts by the US authorities to reflate a credit-driven growth cycle in America will work. The deflationary deleveraging pressures unleashed by the unwinding of structured finance are too large.

Mr Kepper: This latest financial crisis indicates that the world economy has come to be based on a representative monetary system whose numbers can't be valued. Today's monetary system to a large degree is a mental construct that is made workable by the confidence people have in it. When we see very large trillion-dollar failed institutions such as Freddie Mac and Fannie Mae being kept operating with government guarantees, banks with failed practices being bailed out by the government, a lack of transparency in the financial markets and the inability to determine basic value, there is reason to believe there could be a semi collapse of the global financial game. Developments of this kind, where traditional market fundamentals and basis of evaluation don't hold true, could force policymakers to close financial markets in order to control panic selling especially when sellers outnumber buyers and corporate earnings start to fall.

Rowley: Has the crash in stock and other financial markets created buying opportunities yet? Or, if it is still too dangerous to move back into markets, what signs and signals should investors look for to tell them when it is time to move?

Mr George: The stock market crash, particularly in the last month, has created extraordinary buying opportunities and I believe that now is the time to act. You could simply take the 50 best companies in the world with strong balance sheets, strong cash flow, and valuable and sustainable franchises. I would also include some oversold banks. This is an excellent time, as Warren Buffet also argues, to make long-term investments.

Mr Thomson: The crash has been precipitated in no small measure by indiscriminate hedge fund liquidation of good assets as their loans are called by their banks and prime brokers. This means that many good assets now have real value even if the markets have not reached their ultimate bear market lows. A sure sign of value is companies with unimpeachable dividend records yielding 50-100 per cent more than 10-year Treasury bonds. Look at BP and Royal Dutch Shell, for instance. These sorts of opportunities do not arise every day. Studies show that a significant part of the long-term returns from stocks are from dividends. Well covered dividends that can grow are a vital protection against long-term inflation that could well be the result of the explosion of liquidity the central banks are pouring into the markets once fear dissipates and animal spirits resume more normal service.

Mr Wood: I believe that there is likely a relief rally in world equity markets through to year-end driven by declines in signals of risk aversion, such as interbank rates, and growing hopes that the authorities are getting ahead of the problem in terms of their efforts to throw liquidity at it.

But any such relief rally will then unwind in early 2009 with the realisation that a severe economic downturn is underway in the West. I would expect a retest of recent market lows in America next year and quite possibly a move lower, most particularly if the US dollar remains strong in a deleveraging cycle.

Mr Koll: The big performance killer this year has been volatility. Across all assets - stocks, bonds, currency, and commodities - we have seen a huge surge in volatility which kills short-term performance measures. In a way, the rise in volatility reflects the rise in uncertainty. From here, a drop in volatility is the key signal that the panic, that the uncertainty, is coming to an end.

I doubt that we will move back quickly to an overarching bull market in any asset class. But I do think that stock picking will become more and more important. Companies with high barriers to entry, companies that have strong balance sheets and strong management will be the big winners. The strong will get stronger and the weak will wither.

Rowley: If there are buying opportunities, where and what are they?

Mr Thomson: Outside the government bond markets, prices in most asset classes are very much more attractive than they have been except for the bottom of the markets in 2003 and 1974. That's not to say we have seen the ultimate lows. I do not believe we have, but I can foresee a decent recovery rally after the extreme drop into the early days of the Obama presidency. That could easily run out of steam as the magnitude of the challenges and the size of the mountain to climb become apparent again. But where there is great value, it is a time to buy as Warren Buffett has shown. It's not a crime to lock in a profit later.

Emerging markets have been savaged, especially the BRIC favourites. China alone is off 65 per cent from its peak and valuations are accordingly more reasonable. China's growth will slow in 2009 but is likely to exceed 7 per cent whilst OECD members show zero economic growth. Value is obviously there. At the same time, those emerging markets, especially in Eastern Europe - such as the Baltics, Hungary and Ukraine - that ran large current account deficits are in very real trouble and will be seeking assistance from the IMF. They have been decimated but do not have the resiliency of Asia.

Mr George: The best buying opportunities are in the most oversold markets and I believe that the emerging markets such as China and India which have been down 60-70 per cent will rebound twice as strongly as the UK or the USA. The action (this week) of the Reserve Bank of India is a good signal of confidence and I believe we will see domestic investors stepping in to buy shares where hedge funds have been forced sellers and driven down prices to unreasonably low levels. This is an important signal for us. I would not be buying bond markets now.

Mr Koll: It's back to basics now. You must focus on individual companies and their competitive edge, rather than whole countries or asset classes. Yes, global infrastructure spend will rise, probably with a strong environmental edge. So Japan's capital goods companies are in a very good position to benefit from this. Agricultural policy around the world is poised to become more focused on raising efficiencies, so makers of top-notch agricultural machinery should benefit. Medical devices are going to be in hot demand. The theme of global greying - the ageing of the world - should offer big opportunities and any company making products that allow us all to age more gracefully should benefit.

Mr Wood: I would say Asia and emerging market stocks.

Mr Kepper: The current sell-off makes perfect sense. The market is simply recalculating stock values to account for shrinking earnings and cash flows. It stocks can be considered cheap, that is only relative to their values over the recent past when they were grossly overvalued. Current price-earnings ratios can be expected to fall well below their long-term average of 16 before a turnaround kicks in. As corporate earnings started to drop, stocks would have to fall in order to maintain a price-earnings average. From this point of view, stocks are anything but cheap at this time. I would expect stocks to fall another 15-20 per cent before bottoming out. Don't expect any sort of serious rebound until the credit markets recover from the greatest creation of liquidity over the last 10 years that the financial system has ever seen. That will take years. Therefore, the next 12 months or so will likely be a period of much confusion in equity markets.

Rowley: And the outlook for gold and other precious metals?

Mr Thomson: I believe a position in gold absolutely must be retained - in fact, enhanced if at all possible. The sell- off since August reflects the giant margin call that hedge funds have faced as banks are trying to reduce their loan books. There is a huge disconnect between the paper market in precious metals as represented by futures and the physical market as represented by coins and bullion. The latter has been on fire and physical is selling at a premium to the paper form. The US government is up to its usual games making gold ownership more expensive by suspending the production of gold coins whilst, at the same time, debasing the dollar like never before. It is not beyond the realms of possibility that they will try and make ownership of gold by Americans illegal again in any future crisis. Would you rather own gold or the paper of a hugely indebted government whose budget deficit next year could get close to double digits? Silver and platinum are even more depressed but both metals have some industrial uses which are less in demand under present circumstances. They are cheap on a relative and an absolute basis.

Mr George: Gold is at US$730 per ounce today. My expectation is that the price will be three times higher - that is, between US$2,000 and US$2,500 per ounce - in 2010 to 2012. The reason is simply that the amount of paper money created in order to stave off the crisis and reflate the banking system will take about 18 months to feed through into inflation, and that the value of the US$ will again fall sharply as a result. In addition, low or even zero interest rates will favour gold and other commodities. I also expect oil to rebound from the current low levels to at least US$200 within 2-3 years.

Mr Wood: Gold, not oil, should be the ultimate prime beneficiary of the likely coming demise of the US dollar paper standard. My long-term gold bullion target remains US$3,360 per ounce by the end of 2010. Short-term pressure as long as the US dollar remains strong as a consequence of deleveraging. This dollar rally will become vulnerable, the more 'unconventional' the Federal Reserve becomes in its conduct of monetary policy.

Mr Kepper: Gold was and is a form of cash; and it probably always will be. Paper currency, on the other hand, is a promise to redeem in terms of something else - and as national debts mount higher, the chances of default mount with it. Further, though the US prints increasing numbers of dollars, the amount of gold backing up those dollars is small - and will probably get smaller. With the dollar's value falling, people will begin to buy gold; its potential upward rise will then be unlimited. Gold mining stocks are riskier than owning bullion as there are dangers from fire, flood, resource depletion, and nationalisation. But as gold prices climb, so do the prices of stocks. Moreover, many gold stocks average 15 per cent dividends. If your net worth is between US$100,000 and US$1,000,000, 25-50 per cent of your assets should be in gold and silver. Of the gold, a rough breakdown would be 60 per cent in bullion and coins, 30 per cent in gold mining stocks, and maybe, if you have the appetite, 10 per cent in penny stocks.

Rowley: Any final points you'd like to make?

Mr Thomson: Commodities, in general, have been hammered and in some cases, such as oil, are at a level close to the cost of finding and bringing new production on stream. They also have much better value than earlier this year as many of the leveraged speculators have been forced out.

Property in those countries that experienced the biggest booms - the US, UK, Ireland and Spain - still has a way to go to reach the bottom. That may not happen till 2010 or even later. Whilst that situation endures, the consumer will be under pressure to rebuild his balance sheet. The pressure will have to be taken up by government investment in areas such as infrastructure and alternative energy as well as domestic demand in Asia, whose currencies should strengthen against their Western competitors.

Mr George: Finally, I believe that we are now in a new era of less leverage and less debt where capital will be scarcer or therefore better rewarded. Here in Asia we have high savings, and this should be a very valuable support for market and economies in the coming years. There will be a wholesale aversion to risk and to fancy instruments like derivatives in the next few years, and much more focus on fundamental investing and fundamental values. On the whole, I think it is a welcome change.

Mr Koll: The key question is: how active, how interventionist will government get? Yes, the world all over needs public investment and more active industrial policy. But this must lay the groundwork for future private investment. Build the road - but let the private sector build the houses, the factories and the call centres and hospitals on the new roadside. I think the next bull market will start when it becomes clear that government is ready to let private entrepreneurs take over again.


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