Cash may be king for the moment but financial experts favour a plunge back into equity markets later in the year
A 'YEAR of fear' for portfolio investors - or a time of great opportunity? This is the question The Business Times put to a panel of financial experts as 2007 draws to a close. Their answers contained some surprises. Cash may be king for the moment, in the immediate aftermath of the US sub-prime mortgage crisis, and the worst is yet to come in equity markets.
But for all except the most faint-hearted, such a defensive strategy is appropriate only for the short term. Most of our experts favour a plunge back into equity markets in 2008. Bonds are no place to be in the inflationary environment that is likely to develop next year. And while the US dollar has been one of the biggest currency market casualties of this year, it could be the currency of choice in 2008.
PARTICIPANTS:
Moderator: Anthony Rowley, Tokyo Correspondent, The Business Times
Panellists:
Ernest Kepper is a former senior official of the International Finance Corporation and Wall Street investment banker who now heads an Asian financial consultancy.
Jesper Koll is president and CEO of Tantallon Research, Japan.
Robert Lloyd George is chairman and CEO of Lloyd George Management, Hong Kong.
William Thomson is chairman of Private Capital Ltd, Hong Kong and senior adviser to Franklin Templeton Institutional Hong Kong.
William Massey is director, Pinnacle Wealth Management, Tokyo.
Anthony: Welcome to this year-end forum. What kind of year will 2008 be for investors? Could we be looking at a market meltdown - or is the worst now over? Jesper, I know that you have a rather upbeat take on this.
Jesper: This year has been all about sub-prime problems and bad debt. It was a year of fear but 2008 is poised to become a year of hope. Markets will have to climb a wall of worry, but by mid-year, it should become pretty clear that the US and world economy is set for a new growth cycle in 2009/2010.
Robert: I agree. I believe that the worst is over and there will not be a market meltdown. On the contrary, I think markets are reasonably priced and will go higher in 2008.
Anthony: So much for the 'good news'. What about the rest of you?
William M: The worst is definitely not over. More skeletons in the form of higher asset writedowns will appear in the first quarter of 2008, which, together with the possibility of rising inflation and lower consumer spending in the US, will impact investor confidence and drive equity values lower.
William T: I see a very difficult market in 2008, especially the first half and especially in the US, and with much increased volatility elsewhere. We are in for an extended period of sub-optimal - I almost said 'sub-prime' - growth as the credit crunch spreads and morphs beyond sub-prime mortgages to affect regular mortgages, credit cards, automobile loans, commercial property and extends itself thousands of miles from America's shores.
As the lending bonanza unwinds and the financial sector nurses a monumental hangover, it is impossible to know just how devastating it will be.
The global economy is still addicted to credit. Last quarter, derivatives outstanding grew to US$681 trillion - over 13 times world GDP - and it grew by three times world GDP in the third quarter of 2007 alone. Ten years ago, derivatives amounted to about the same as world GDP.
The US seems to be making many of the same mistakes the Japanese made when their bubble burst. The health of the financial system is threatened from banks to brokers, to bond insurance companies, to Fannie Mae and Freddie Mac, to hedge funds, to individual mortgage holders.
Ernest: No one really has a firm grasp on the extent of the damage to major banks' balance sheets. But US housing weakness and high energy prices, along with billions of dollars in write downs at financial institutions, have sparked fears of slower employment growth and a rising jobless rate which are likely to bite into real income and confidence.
Housing will not bottom until late 2008 at the earliest but the bigger danger is the lag effect that the housing market and reduced credit availability will exert on consumer spending, which will probably start contracting in the first half of next year. Rising US exports, a more solid tone to the global economy and the effects of a weaker dollar as well as an accommodative monetary may lower the recession risk but will not eliminate it.
Anthony: So, going into 2008 with the sub-prime crisis still unwinding, is it wise to be in anything for the moment other than cash - or is this a good buying opportunity?
Jesper: Cash is king (at the moment), but throughout 2008 a switch from cash and value towards growth should be anticipated; no need to rush, but great return opportunities await as the effectiveness of global liquidity and global capital flows re-asserts itself.
Robert: I believe that this is a good buying opportunity. The Abu Dhabi Investment Authority's purchase of 5 per cent of Citibank was an important event in demonstrating the very deep pockets of oil producers and their perception that some of the big US banks are now undervalued. Clearly, Temasek in Singapore saw the same opportunity with UBS.
William T: It is too early to be brave with new money for other than the longer-term investor. In this environment, I like both gold and silver, and an investor should be overweight them as well as Asian currencies. China is developing a serious inflation problem and I believe they are behind the curve in tackling it. Faster currency appreciation has to be part of the solution to that problem. As the renminbi appreciates, that allows other Asian currencies to appreciate against the dollar and eventually against the euro too. Opportunities will present themselves as the situation unwinds in 2008. You already see sovereign wealth funds entering the large financials albeit at junk bond yields. There should be plenty more of that as the US financial system has to be recapitalised.
William M: In the broad market, equity values will be lower but there will be some excellent buying opportunities in 2008 for liquid investors in oversold sectors such as banking and property.
Ernest: There appears to be a consensus on Wall Street that this is just the start of a lengthy period in which the negative effects off sub-prime crisis are going to be felt, but I feel that now is a good buying opportunity for long-term investors.
Although equities may struggle early in 2008, the environment should improve once growth worries recede. During 2008 as a whole, equities are likely to outperform cash by a margin sufficient to compensate for their risk. We are still in a strengthening long-term commodities cycle and uranium, oil, and iron ore stocks, as well as banks such as Wells Fargo, show good buying opportunities at the present time. I expect international stocks to post positive returns in 2008, with the best performance continuing to come from emerging markets.
Anthony: Specifically, what about equity markets? Will they fall further in the New Year, and which ones are likely to recover first?
William M: I do expect markets to fall in the first a quarter of 2008 and the recovery to be led again by the BRIC (Brazil, Russia, India and China) emerging markets sector.
William T: I expect the main US and European markets to be volatile and work lower in the first half of 2008. If there is a recovery in the second half, I would expect it to be sub-par as the excesses will take a long time to work off. In addition, the markets will be trying to assess how the new US president, who will be elected in November, intends to address the massive problems he or, most likely, she will inherit. If markets are anticipating significant tax increases in 2009 and beyond, there may be a rush to sell in 2008 to avoid increases in capital gains taxes.
Emerging markets will be the better recovery story even though they are no longer cheap the way they were before 2004. One thing to look for is where Chinese money will flow as investment outflows begin to increase.
Ernest: Equity markets will continue to be volatile across the board, and a major factor in this will be the economic data and how it is interpreted. Oil stocks, agricultural stocks and, in general, natural resource-based equities as well as the banks would tend to recover first in the event of any sharp downturn. Large-cap equities offer significantly better growth opportunities than smaller-cap stocks, as they outperformed small caps in 2007, and are expected to continue this trend in 2008.
The Japanese equity market seems to be emerging from the problems of deflation etc. related to the bubble in the early 90s and I expect the Japanese equity markets to recover and show some comparative stability in comparison to other markets
Robert: The reflation policy of the Federal Reserve will benefit most markets, but especially emerging markets and, of those, I expect Asia to perform best again in 2008.
Anthony: What about bond markets in the New Year?
Robert: With the prospect of inflation rising slightly in 2008, I would not recommend any fixed-income markets at present.
William T: I don't find bonds attractive beyond the ultra-short term, since I fear the only way out of the dilemma we are facing is inflationary with the US leading the way.
The only bonds I like would be selected emerging markets bonds since they return equity-type yields, but even this class is somewhat overbought today.
Ernest: I believe equities will outperform bonds in the New Year. Bonds will struggle to deliver a return above cash in 2008, but for those who do want to be in the fixed-income market, it is probably better to be in bonds with shorter maturities. Inflation expectations will start to grow as a consequence of the Fed's easing stance. This would naturally place upward pressure on bond yields, and so over the whole of 2008, government bonds are likely to deliver sub-par returns. Corporate bonds will likely also struggle next year.
Anthony: What about currency markets? I know there are differing views on this.
Jesper: Currency market adjustment has been remarkably smooth. The dollar's decline has been broad-based but gradual. As prospects for a US economic recovery into 2009 rise, so should prospects for the dollar.
Robert: I also expect the dollar to recover at some point during the next few months. It is currently very oversold, especially against the euro.
William M: Currency market turmoil will continue into the New Year and the utmost caution is necessary for equity investors, but they also should be mindful of buying opportunities that could arise from the turmoil.
William T: I believe we have more of the same - periodic US dollar rallies in an overall dollar bear market. It is clear the US authorities are happy with a lower dollar so long as the decline is orderly. I would note that the dollar's decline is having an effect on the current account deficit. From a peak of minus-7 per cent GDP, we are down to about a 5 per cent deficit, and a sustainable rate around 2.5 per cent should be able to be achieved in late 2008/2009 with a somewhat lower dollar. But the potential for the decline to become disorderly is definitely still there. Stick with the better Asian currencies, reduce exposure to sterling and hold the euro, Canadian and Australian dollars.
Ernest: Currencies will undoubtedly be the most volatile markets in coming months. Expect Asian currencies to not only continue strengthening against the dollar, but also to start appreciating against European currencies.
As foreign exchange reserves at Asian central banks have increased significantly over the past years, questions are being raised about their ability to maintain their heavily managed currency regimes. With higher inflation, it can be expected that Asian central banks will tighten monetary conditions by allowing their currencies to strengthen.
I expect increasing pressure on Asian central banks to loosen currency links to the US dollar. Carry trades - borrowing in low-yielding currencies to invest in higher-yielding assets - have become risky and will be substantially reduced. Forex markets will provide speculative opportunities. The euro appears overvalued. While Asian countries have been reluctant to allow a meaningful appreciation of their currencies against the dollar, they have gained against the euro. In 2008, I expect Asian currencies to appreciate significantly against the dollar as well as the euro. The biggest risk could be holding the British pound.
Anthony: Asian investors put a very small proportion of their portfolios into Asian securities (less than 6 per cent, according to IMF data) and the bulk into US and European markets. Do you expect this pattern to change in the wake of the sub-prime crisis?
William T: It ought to. Asia will continue to be the fastest-growing region and represent a growing percentage of world GDP. Portfolios should reflect that fact.
Robert: Yes, I do expect that Asian investors will progressively increase their exposure more to their own hemisphere than to the US and Europe. Of course, one major factor will be currencies. The euro looks overvalued now, but many of the Asian currencies, including the renminbi and others are undervalued.
Jesper: Asia is moving on from being the factory of the world to being a capital provider and investor to the world. To enable greater capital flows into domestic Asian equities, Asia's corporate governance, accounting rules and corporate transparency must improve greatly. Without this, Asia's risk capital will continue to move overseas rather than stay at home.
William M: The sub-prime crisis has shaken Asian Investors but I do not believe it will materially change their investment philosophy. US and European markets will still remain the major investment areas.
Ernest: With a falling dollar, American assets are cheaper for Asian buyers, so this could result in an increase in purchase of assets in the US or in European markets where currencies are comparatively weaker.
Anthony: Thank you all and let me wish you and all of our readers a Happy and Prosperous New Year in 2008.
