Apple’s iPhone is hitting the markets next week. There will be a frenzy of activity and then things will become normal. But that is common for any new product or concept. Structured finance and related products were similar in nature for investors in the last 12 months or so. It was an example of jumping on the bandwagon early on rather than careful consideration typical of seasoned investors. Last year alone USD 1000 billion of packaged debt was issued in Europe and the US according to data from the Bank of international settlements. Alan Greenspan had expressed the view that the market price of risk is too low for too long.
Recent fall of Bear Stearn’s hedge fund forced its assets sell off and came to realize the market value of modern assets like CDOs ( Collateralized debt obligations). CDO and other packaged debts are valued based on non-market methods and complex mathematical modelling. It is strange that investors bought assets without really considering it’s resale value. Well, such is the effect of any new product or concept. We did see that during the time of the dot com boom, investors invested in companies without considering a revenue model.
One third of the last year’s packaged debt was based on underlying sub-prime mortgages. Bear Stearn’s was indeed a causality waiting to happen. Reports say that there are more European CDOs than US CDOs with exposure to US sub-prime derivatives.
This week, various corporates including Arcelor Finance put plans for its euro denominated bond deals on hold. Investors are emerging out of the honeymoon period of the new products in the packaged debt market and it is causing ripples in the entire corporate debt market. We may see a sharp decline in Private Equity activity and other industries which rely on corporate debt. But everything is happening for the good. We may soon see more mature valuation models for CDOs and a mature corporate debt market.
The value of equity, is predominantly to do with the “fundamentals” of a company. Similarly, when it comes to the value of a currency, it should ideally be dependent on the economic performance of a country. For example, this week we saw a downward trend for Yen based on fundamentals. Japanese retail sales and consumer price inflation data was weaker than expected and brought down the value of Yen. When the performance of a company improves, the stakeholders of the company are happy and we see a better performance of the price of its equity. But when a country’s economic performance improves (thereby increasing the value of its currency) “stakeholders” get worried and starts putting controls, or hitting the brakes on the economy by increasing interest rates. For example, IMF Chief Economist commented that the Euro zone is growing economically. The 13 country region is growing its GDP, by 2.7%. Current monetary policy is about applying brakes when there is growth. So we may see an increase in interest rates from ECB very soon. It will be the same in the UK as we will most probably see an interest rate hike next week.
Economic growth is good based on human judgement. It brings more jobs and for the common man it brings more disposable income. Today we are forced to agree based on all the theoretical factors of current monetary policy, that the central banks should curb liquidity and bring a “correction”. But, there should be a better way. I had the opportunity to meet Hung Tran ( Deputy Director, Monetary and Capital Markets Department, International Monetary Fund) in London at the Euromoney conference on 27th. Regarding my question that there should be a better way, he commented that we may see a new policy in our lifetime and possibly in the near future.
This week, the annual report by the International Monetary Fund’s (IMF) economists gave clear warning for an imminent US recession. In the UK, we just missed another .25% rise in interest rates by one vote despite the fact that the Bank of England’s (BoE) Governor voted for a rise. The minutes of the BoE meeting has made the British pound to go high against the dollar. These are not good signals and we have already seen the fall of bond prices.
But on a contradictory note, we saw one of the strongest months in corporate bonds rising around EUR 10 billion in Europe. It shows the investor appetite for corporate bonds remains strong or there is too much supply of cash. We are seeing the effects of free movement of capital across boundaries. Some say it is the oil money from Russia and the Middle East. Normally when too much cash follow too little goods, it only augments inflation.
For the last three years, we saw a regular decline of funds using macro strategies. But as we know it is very difficult to beat the market as the analysts and investors are good at what they do. It could be possible that the fundamentals in determining global macro factors are not really managed well. It is difficult to consider a solution, but it could be time for the IMF to care for the global financial balance rather than the individual countries alone. In an interconnected world where there are no boundaries for capital flows, it is time for some control on the overall scenario.
This week the financial press was talking about the fall in US Treasury bond prices. The bond market seems to have a stronger correlation to the financial decisions for an average investor.
A bond is a fixed-interest security, giving a fixed return for the money you pay. For example, a £100 pound should yield £6.5 on a 6.5% bond. In this scenario, an investor is ready to pay £100 for the right to receive £6.5 interest. But if the general consensus among investors is that the interest rates are going to go high, they will expect a higher yield. For example, if the consensus is to expect 7%, then they will expect an interest of £7 for the £100 bond. In the case of a bond issued at a fixed rate, they may give a lower price for the bond to receive the fixed interest payment of £6.5. In this case, the price for the £100 falls to £93. So when the yield increases, the bond price falls.
Based on this principle, the falling price of US Treasury bonds is giving an indication that the market is expecting a growing US economy and more demand for capital and thereby higher interest rates. It can be read as the possibility of rising inflation also. As the cost of borrowing is going high, businesses may have an increased cost of capital which reduces their profits, causing a fall in equities.
Based on the above analysis, an average investor may consider putting the money in a normal savings account or in bricks and mortar. For example, in the UK, it may be wise for an average investor to re-mortgage for equity release at a fixed interest of 5.49% and put the money in a penalty free savings account of 6% and above. As the interest rates are going high, the market will see a slowing housing market with more properties coming to the market. This can give an opportunity for investors to acquire housing stock for long term investment purposes, giving a return of 10% if the location is right.