The International Monetary Fund (IMF) updated its forecast for global growth this year and next. It projects growth at 5.2% for both these years. This is an impressive number and hence runs the risk of being spectacularly wrong, particularly for 2008. Further, financial market action last week suggests that the forecast upgrade could not have been more ill-timed.
Stocks in the US declined by 2-3% on Thursday and most Asian markets, including India, responded in sympathy on Friday. Many expected US stocks to recover on Friday. They did not. That would have caused some nerves to fray. The questions are how long will this run and how deep would the correction be.
Investors might find it injurious to their financial health to draw solace from the sunny answers of most investment strategists on Wall Street. They did not warn us on the spillover from US mortgage borrowers, lenders, brokers to securitized products, to leveraged buyouts, to credit markets and to Wall Street banks and brokers. Investors would look for clues in fundamentals to decide if this would last or prove to be shortlived.
They would then turn to forecasts such as the one that IMF made recently, the strength of corporate balance sheets, growth rates in most emerging economies, and to what they see as reasonable valuations in many stock markets. In doing so, they would be committing a mistake. The rally of the last five years was not about fundamentals, but about a rose-tinted view of the economic fundamentals of most countries in the world and abundance of liquidity provided by banks to hedge funds, hedge funds to private equity managers, banks to private equity managers and now sovereign wealth funds—funds set up to manage the foreign exchange reserves - investing in risky assets.
A friend who co-manages a hedge fund incubator, while demurring at my sober outlook for global asset markets in the coming years, did admit that banks were ready to provide leverage to the extent of 49 times and, in some cases, even 99 times to start-up hedge funds with no track record either in investment performance or in risk management. That sums up the problems with global finance. It has been all about returns, nothing about risk.
Some segments of this assembly line of liquidity are now shutting down. Readers should appreciate that this assembly line was lubricated with multiple layers of leverage. A hedge fund uses leverage as mentioned above to buy assets. Securities packaged out of mortgages are leveraged and they are repackaged further. Hedge funds buy the lower-rated tranches of these double-packaged debt securities. Some hedge fund investors, too, are leveraged. Hence, a decline in asset value is like a spark that runs through the wires to the final explosive quickly. Here, the leveraged funds explode rather quickly and that hurts a lot of investors because they have used debt and quickly face margin calls. Credit tightens or seizes up at many levels.
That is the difference between 2006 summer and now. The correction then was triggered by cyclical tightening concerns. Now, it is the bursting of the credit bubble and, repeat, not just housing finance. Therefore, its path would be relatively more volatile, unpredictable, prolonged and punctuated by large rallies and false dawns over the next few years.
Optimists will point out that sovereign wealth funds would step in to provide stability to markets. It is possible. However, in doing so, they would be playing the role of Greenspan who always stepped in to help stabilize financial markets with interest rate reductions. That spawned bubbles in Internet and technology stocks and in housing finance. But that did not prevent the technology bubble from bursting. It probably made the bubble bigger. That is what sovereign wealth funds would be doing if they prop up markets. They might be able to delay the inevitable, not make it disappear.
Into this mix, one must throw the volatility that the price of crude oil would cause to economies, to the inflation outlook and asset prices, particularly in Asia. Asian economies have only been superficially strong. Now that the tide of liquidity has withdrawn, the rising price of oil would reveal that many Asian economies and markets were swimming naked.
Mohammed El-Erian, the president and chief executive of Harvard Management Co. and a faculty member of the Harvard Business School, in an excellent article in the Financial Times on Thursday succinctly observed that we may be exiting the world in which “individual investors’ performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes”. In the coming years, however, investors’ performance would be a function of the degree of their composure.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org