In 2003, during the global fear of recession, quite substantial foreign investments started flowing into direct equities in Australia, providing the necessary impetus to turn our market. The reason was the market was cheap and trading at a discount to its peers. Of course, the far-sighted investor would have recognised the China development story and its increasing dependence for commodity supply. Enter Australia’s large liquid resource companies.
The consequence of these inflows was that a very strong momentum took hold in the Australia market. Really, over the past couple of years, any investment strategy that has looked at earnings momentum and price momentum has made money. Literally, following the money has made money.
The property trusts sector stands out immediately as a clear example of what funds flow can do. This sector was up 34 per cent last year, and actually contributed 15 per cent of the 24 per cent return that the stock market did last year. Almost every single constituent stock within that sector went up above market levels of 24 per cent.
However, while money flows create market momentum they also create distortions in the market, including dampening volatility. Research shows markets exhibiting strong upward momentum are structurally less volatile than a market that is very choppy. The Australian market has actually now declined to below historical long run averages in terms of levels of volatility,as have global markets.
Since volatility is a measure of risk, the question is do liquidity flows actually make the markets less risky? To answer this we need to follow the money back to its source. In other words, what specifically are the liquidity flows that are ostensibly dampening down global market volatility?
As we all know, you either have money, or in the case of banks, you print it. So who has got the money? China and Asia certainly do. With a savings rate of over 30 per cent, the region has massive amounts of funds that need to be invested. Hedge funds too have it. They are aggregated representations of savers globally. Oil producers – they have loads of it — something like hundreds of billions of dollars per annum that require to be invested.
On the flip side, you have the consumers of money, which is clearly an activity dominated by the US, generally sourcing its imports from developing markets. This consumerism is clearly revealed in the massive US trade deficit. However, the US doesn’t have the money to pay for these goods: it’s all bought on credit.
It issues bonds, which are increasingly bought by foreigners. Foreigners buy five times the amount of financial assets than occurs through US domestic purchases. This amounts to trade financing on a massive scale. The result is a dual deficit, born from the massive dislocation between who is saving — who has the money — and who is consuming it.
As noted, if you don’t have the money, you print it. And who is printing the money? Japan is, of course, and in very large amounts. For the last decade it’s been conducting a massive monetisation effort. It’s really through monetisation and a massive currency intervention that Japan has been able to sustain its zero interest rate policy, as well as keeping the yen competitively depressed.
However, the side-effect of this has been that the world is using Japan (and Switzerland to a lesser extent) as a source of cheap funds. It is the leverage bank to the world. This is the so-called ‘carry trade’, worth an estimated US$330 billion. People borrow in Japan, hedge the cross-currency rates, and invest in high-yielding currencies and investments, predominantly US bonds.
Alongside Japan, the US too is a massive printer of money. As we know, former Federal Reserve Bank governor Alan Greenspan really favoured accommodation post any financial shocks. There is even a name for this accommodation of financial shocks, the ‘Greenspan put’. The question is whether his successor, Ben Bernanke, will also accommodate shocks. He has in fact gone on record as supporting accommodation.
Bernanke would want to ensure interest rates in the US are kept at a level that will always allow the Federal Reserve Bank to be in a position to accommodate. He doesn’t want to get stuck in a Japan-type situation where interest rates are too low. Neither does he want to get stuck in an inflationary situation — potentially from an oil shock — where the Fed cannot actually drop rates. In order to keep in that zone, Bernanke will probably allow the consumer to suffer a little more than what Greenspan has done in the past.
As a result of this accommodation policy, money supply pops every time there is a shock. For example, after the so called Asian crisis in 1997, the Y2K crisis, 9/11, and the fear of recession in 2003, money was pumped into the system to the extent it actually gave birth to a boom. The Asian financial crisis eventually gave rise to the dot.com bubble, Y2K to the property boom, 9/11 to sustaining the property boom, and the 2003 fear of recession to the commodities boom.
It’s almost as if we have moved from the traditional economic cycle of boom to bust to one of much more boom to bubble. Bubbles are rotating through our asset classes — private equity is effectively an example — as cheap money chases after cheap assets.
While the initial two booms of technology and property, as we know, are wealth creating, it’s not clear whether the commodities boom is going to be wealth creating or detracting. If, as has been suggested, inflation does take hold as a result of commodity price increases, then the Fed could have given birth to quite a negative beast. However, there is no sign of that at present.
In summary, what has happened is that global investors have become addicted to liquidity. We are addicted to the belief that the Fed will save the day when there is a shock. As a result, investors are not asking a premium for holding risky assets. For example, the premium over the Fed funds rate that investors are asking for holding a low-quality bond is now at historical low levels.
Similarly, in equities investors are pricing low quality stocks in the same way they price high quality stocks.
To say that the markets are not effectively pricing risk is a massive statement to make, because the financial markets are all about effectively pricing risk.
So what could happen to force risk to be repriced? It could be the US getting out of its comfort zone as a result of an entrenched inflationary or deflationary situation. It could be something that happens in Japan that allows the authorities to hike interest rates, or more likely allowing the yen to appreciate, thus crushing the carry trade. In any of those scenarios, the closing of the liquidity flows would result in a very disorderly repricing of risk. Those asset classes that are structurally more risky will be the worst hit and they will hit extremely hard. Contagion will be there, and it could spread into even less risky sectors.
The risk repricing issue we are currently seeing in the sub-prime mortgage sector in the US is only a taste of what could happen. That little risk repricing issue is happening against the backdrop of all the liquidity taps remaining open. I’m talking about a situation when they are switched off.
The central banks, clearly, are hoping they can gingerly tread their way to a time when all this resolves itself naturally. They would be putting their faith in structural rebalancing to close off the taps, which is when those entities with the money start to spend it. If China/Asia spend more, largely as a result of urbanisation, then the trade imbalances should start to become less sharp. And that would feed through into reducing some of the capital imbalances we are seeing.
And by that time, Japan will hopefully have managed to drag itself out of recession and have closed down as the leverage bank of the world.
However, there is a very low probability that the central banks d turn off taps and control the situation in anything else but a disorderly manner. It would require unprecedented levels of co- operation. The issue about the carry trade is its very hot money and very quickly reversed.
In a situation of a disorderly repricing of risk the only thing you would want to invest in is gold, because gold is a store of value that sits outside this whole risk repricing/misprising framework. The metal definitely looks like an attractive alternative investment, while there is this very large mis-pricing of risk out there.
Suzanne Taville is joint head of research at van Eyk .
