The Beginning of the End?
Business Times Singapore Investment Roundtable June 2007
The beginning of the end?
The bull market appears to have peaked and a major correction in global bonds and equities is looking more likely, say panelists
Moderator: Anthony Rowley, Tokyo correspondent for the Business Times
Marc Faber, investment adviser and publisher of the 'Gloom, Boom and Doom Report'
Mark Mobius, president of Templeton Emerging Markets Fund mc, and director and executive vice-president of Templeton Worldwide Inc
William Thomson, chairman of Private Capital Ltd in Hong Kong
Christopher Wood, managing director and equity strategist at CLSA Asia-Pacific Markets in Hong Kong
LIKE the often-prophesied end of the world, a major correction in global bond and equity markets is a long time in coming - so much so that many investors are tempted to think that it may never happen. But, as two of our eminent investment experts comment in the panel discussion below, the most dangerous words in the English language are: 'This time it is different.'
The 20-year bull market in bonds is already looking very shaky, following recent sharp rises in government bond yields. While the market unwinding is unlikely to happen overnight, the implications for ultra-narrow credit spreads in general are clear to see. As central banks tighten monetary policy, in belated recognition of rising commodity and asset prices, the liquidity bubble that has propelled markets - emerging markets especially - to record highs is expected to burst. The correction could be savage, as our panelists point out.
Anthony Rowley: We're privileged to have some of the best in global investment talent taking part in this Investment Roundtable, at what could be a critical turning or tipping point for bond and equity markets.
Our panelists are veterans on the world investment stage, and also in these discussions. A very warm welcome back to all of you. Marc, let's throw the ball into your court first. Does the recent sharp rise in bond yields signal the beginning of the end of the sustained global bull market in bonds, and possibly a bear market in equities too?
Marc Faber: We had a more than 20-year bull market in bonds - Sept 21, 1981, to June 2003 when the 10-year (US) Treasury bond yield fell to 3.3 per cent and the JGB (Japanese government bond) yield fell to less than 0.5 per cent. We are now at the onset of a major bear market in bonds worldwide that should bring interest rates above the level in 1981 when US Treasuries were yielding over 15 per cent. But this process will take at least 10 years. In this environment stocks will not do well in real terms but will rise in nominal terms. How high will depend on (US Federal Reserve chairman Ben) Bernanke's money printing presses.
William Thomson: I believe the bull market in US Treasuries that began in 1980 peaked in 2003 and that we have been in a long-term topping action since. The recent rise in interest rates indicates that bond prices are probably moving into a lower trading range with higher yields than we have become accustomed to. Central banks have been behind the curve in raising rates and until recently they were beguiled by phony, low-inflation numbers. As a result, real interest rates, after adjusting for inflation, have been too low. Commodity price inflation (in terms of food, energy and minerals) is now seeping through the global economy and boosting even government-manipulated inflation readings. Thus, interest rates are rising as central banks take belated notice. Equities are overbought short-term and due for some consolidation.
The exact timing of a bear market will depend on many factors in individual markets including, but not limited to, interest rates. A bear market next year would not surprise me since the global expansion will be very long in the tooth by then, and markets will be trying to assess possible changes in US fiscal, monetary and possibly
protectionist policies in 2009 with a new US administration.
Christopher Wood: The 10-year US Treasury bond yield has broken above the long- term trend line, in place since the beginning of the great bond bull market back in 1981. The recent equity rally has occurred in the context of rising government bond yields, just as the sell-off in February/March occurred in the context of falling bond yields.
All this suggests that the Fed model, where hundreds of billions of dollars of portfolio capital is allocated globally on the relationship between bond yields and earnings yields, has broken down.
Anthony: Even so, it is often argued that a 'new paradigm' is at work in the equity and bond markets - one that has invalidated past investment cycles and boom and bust theories.
Mark Mobius: Someone once said, 'The most expensive words in the world are: This time it is different.' There is no new paradigm at work in equity and bond markets which would invalidate past investment cycles and boom and bust theories. The nature of markets is such that there will always be excesses in bullish moods and bearish moods. In 1999 and 2000, the majority of investors felt that we had entered a new paradigm and earnings did not matter but the 'burn rate' (the speed at which companies could spend and expand) was more important. Of course that mania resulted in disaster for many investors.
William: I agree. That long bull market seems over and we may enter a bear market or a longer trading range at higher yields than in recent years, reflecting higher underlying inflation.
Marc: There is no new paradigm but there are central banks that expand money and credit at a fast pace and create 'excess liquidity'. This is particularly true of the US Fed, which through its expansionary monetary policies led the US to have a close to US$800 billion current account deficit, which then leads to a 'savings glut' and excess liquidity around the world. This liquidity then drives all asset markets, including stocks, commodities, real estate, art, collectibles, and even until recently bond prices, higher.
Anthony: If the music has to stop, or the tempo to slow sharply, when is that most likely to occur?
Mark: No one knows when the music will stop and the party end. Normally, however, when everyone is unanimous about the viability of the market and the impossibility of it going down is when the market will probably crash. It's just like when you have a party with lots of alcohol. Everyone is happy and gets drunk. They feel wonderful and the world is bright. Then the alcohol wears off and you wake up with a hangover. It's all over.
William: My crystal ball is cloudy right now. This upswing has been very strong globally. The imbalances we have talked about remain but have not as yet caused real upsets. But they will have to correct sometime, either violently or gradually. My best guess is that the new US president - if there are tax and other policy changes in 2009, the markets will begin to anticipate them ahead of time, probably in 2008, maybe later this year, adding uncertainty. On top of that, the Chinese may want to cool their economy after the Beijing Olympics. Higher interest rates, in the interim, globally should have some dampening impact.
Christopher: The continuing US housing slowdown could still be the source of a renewed growth scare that will hit markets in coming months. Rising bond yields would surely pose a blow for the US housing sector, which continues to deteriorate, if the breakout on the 10-year Treasury bond yield is sustained.
Marc: It will stop when the excess liquidity gradually dries up. This can happen for a variety of reasons. Consumer price inflation could accelerate and economies overheat, thus draining money from the financial sector into the real economy. Or it could happen because of illiquidity in the US household sector, which would curtail imports and lead to the current account deficit of the US no longer expanding. There are already some clear cracks in the global asset bubbles: US housing prices, the sub-prime lenders, investment banks, and most recently, the bond market. The second half of this year could become painful.
Anthony: What, in your view, is most likely to be the factor that will precipitate a correction or crash in markets?
William: We can only hazard guesses. More than likely it would be some event that markets cannot discount - say, an attack on Iran, unrest in China, or protectionist measures in the US by a new US president as the result of a recession. If the correcting event is unexpected, and of a major kind, it could cause problems with derivatives - leading to financial instability.
Christopher: Rising credit spreads remain the key risk for equities and all other financial asset classes since they have the potential to bring an abrupt end to the global credit bubble of which leveraged buyouts have been the latest most extreme manifestation. Credit is much more mispriced than equities.
Marc: Excess liquidity has been driven by the US current account deficit growing from 2 per cent of GDP in 1998 to close to 8 per cent now. Growth of the current account deficit has slowed down as the US consumer is struggling. If US inflation were properly measured, we would already be in a phase of stagflation in the US. (The rate of new money flowing into the global system) has slowed down considerably and so not every asset bubble can continue to expand. The global bond market was the first casualty.
The reason that other asset markets have continued to soar is, however, increased leverage and a flight from cash into assets as people rightly begin to realise that paper money's purchasing power is collapsing. Therefore, any catalyst, no matter how small, could one day reverse investors' expectations and lead to a process of de-leveraging and a collapse in asset prices.
Mark: The underlying viability of markets is earnings power. If market participants think they can make profits either short-term or long-term, they will continue to hold investments and even invest more. Therefore, we must look for that event or series of events which lead to people thinking that the ability of their stocks to make money for them has ended. The perception of earnings power viability can last a long time but the trigger that tips the scales and causes people to act can be a relatively meaningless event which is really unrelated to the market itself.
Anthony: Is it equity or bond markets that are most at risk of a severe and lasting correction?
Marc: Emerging stock markets are now vulnerable because they are the most extended. They were the prime beneficiaries of the excess liquidity.
William: They say in America, when the paddy wagon comes round, it takes the good girls with the bad.
Christopher: Neither is at risk of a severe and lasting correction until credit spreads blow.
Then only government bonds will go up.
Mark: Equity markets tend to be more volatile but even bond markets can take a severe beating in a strong downtrend.
Anthony: Is a correction likely to impact developed and emerging markets equally and which ones would suffer most severely?
Christopher: All Wall Street-correlated stock markets are likely to be impacted.
Mark: Those markets that have risen the most will probably suffer the greatest percentage falls, so emerging markets, since they have risen more than developed markets, should have greater declines.
William: History would indicate that emerging markets would be slightly more growth potential and should be bought on significant weakness.
Marc: Emerging markets would suffer the most in a global tightening environment coming from the US current account deficit no longer expanding.
Anthony: What would be the likely magnitude of a correction in terms of percentage fall?
Mark: A severe market correction could range between 20 per cent and 70 per cent.
William: That is impossible to say. It depends on the reason for the reaction and will vary from market to market. Ten per cent is hardly a correction; 25 per cent does not seem unreasonable; 50 per cent seems far too great unless we have a true crash, especially as we had one like that in 200 1-3.
Christopher: If credit spreads blow, a bear market would ensue which would mean 50 per cent-plus corrections. Otherwise, corrections are likely to be limited to 10-15 per cent.
Marc: Once the shares of Goldman Sachs are down by 20 per cent from their peak the phones at the Fed and at (US Treasury Secretary) Hank Paulson's office will ring asking them to cut interest rates to support the asset markets. So, who knows? But in real terms (in gold terms) US financial assets will be 'toast' for a long time.
Anthony: Thank you all, as ever, for a very stimulating discussion and we look forward to welcoming you back - before or after the 'crash'.