Markets marching in
step into trouble By Max Fraad Wolff
The global equity-market surge is nearly
four years old. Despite short, sharp swoons in the
spring/summer of 2006 and February 2007, the trend
is clear. Since 2003, global indices have surged.
Emerging markets - represented by Morgan Stanley
Capital International - in Asia, Latin America and
Eastern Europe have moved upward in very tight
correlation.
The S&P 500, Nikkei 225
and Dow Jones Euro Stoxx have moved similarly and
in lockstep. The past three to four years have
seen a worldwide spike above trend. Markets have
been "randomly"
walking hand in hand. This
reminds us of the recent global run-up in
real-estate prices. However, the correlation is
greater and price movements are more rapid.
The past three to four years have also
been marked by consistently loose credit standards
and massive credit and monetary aggregate growth.
Steady and low inflation has spread far and wide.
Growth has been above trend, with no
emerging-market region performing below 5% in
2006. In the period 2005-06, the emerging-market
average growth rate in gross domestic product was
7% in constant 2000 dollars. Across the period
1960-2000, the average growth rate was 4.75%.
Emerging-market bond spreads have declined
by 60% measured against the 10-year US Treasury.
Basic commodity prices have moved up and stayed
elevated. These have been great times for growth
and even better times to be invested in emerging
markets. Returns in established markets have been
Europe-led but strong in the US and Japan. Nearly
everyone has been in grand equity-price expansion
mode.
Our interest centers on the high
correlation and the drivers of recent events. We
are concerned about correlation as it suggests
potential for unusual risk as equity markets
eventually return to earth. The drivers are
clearly global. To position for rougher sailing in
the right direction and the inevitable downdrafts,
a basic understanding of the recent global run is
required.
Experience has starkly taught
that unusual asset-prices correlation can cause
real trouble when rising tides turn into receding
waters. The LTCM saga, among several, serves as a
reminder that unusual correlation can carve a
swath of destruction through the best of models
and assumptions.
To what do so many owe
their expanding fortunes? What are the new
correlated vulnerabilities taking shape alongside
the recent shared run-up?
Financial
deregulation and integration, exemplified by the
merger wave in exchanges and financial firms, is a
powerful driver. Capital is far freer to roam in
search of returns. All market swords have two
edges. Not since the years before World War I have
international capital markets been so wide open.
Technological and communication revolutions make
the new freedoms far more rapidly actionable.
The end of the colonial period -
particularly after World War II - has produced
many more independent states. They are now free to
join the fray. This allows massively greater flows
and centralization into larger funds. Sovereign
wealth funds have swollen to more than US$2.5
trillion alongside massive pension, insurance,
mutual, hedge and private-equity funds. Massive
asset portfolios and newfound opportunities for
leverage and movement buoy spirits and convince
leading participants that they are the new masters
of the universe. This attitude drips from the
actions and speeches of finance personas in
London, New York and beyond.
The past
decade is defined by large upward redistributions
of wealth. The industrialized world, led by the
United Kingdom and the United States, has seen
rising income and wealth accrue to top
percentiles. These are the folks who buy stocks
and bonds, allocate to hedge and private-equity
funds. The more of a growing pie they get, the
more they spend on assets.
Top marginal
tax rates have fallen and capital controls have
been removed. Capital-gains taxes have been cut
and myriad ways around taxation have been found.
The shares of national products going to corporate
profits are around or above historic highs. The
sheer wealth going to leading institutional and
individual asset buyers is flabbergasting. The
Merrill Lynch Cap Gemini 2007 World Wealth Report
makes this very clear.
Rapid growth in
wealth and the population of high-net-worth (HNW)
and ultra-high-net-worth (UHNW) individuals soared
across 2006. Growth rates in the developing world
were in excess of 10% across regions. By the end
of 2006 there were 9.5 million individuals with
$37.2 trillion in financial assets. Redistribution
helps asset markets by creating a positive
feedback loop between rising demand for and
valuation of assets. Funds raise record cash in
record time despite record numbers of hedge and
private-equity investment options. Labor has fared
less well.
Money has been super-abundant.
Central banks - led by the US Federal Reserve -
have created vast quantities of cash. This cash
sloshes around the world. The US runs massive
deficits with oil and East Asian exporters.
Americans globalize their easy monetary policy as
vast export earnings for others. Hundreds of
billions of these dollars enter exporter
economies, increasing credit and purchasing power.
Much ends up in official reserves.
Not
coincidentally, foreign-currency reserves have
exploded since 2003. IMF Composition of Official
Foreign Exchange Reserves data indicate that
developing-country reserves grew from $1.6
trillion in 2003 to $3.6 trillion in 2006. Rising
tides are linked as vast hoards of cash - born of
loose monetary policy and trade imbalance - pass
through global asset markets. As flows rise,
upward pressure is put on asset prices and
correlation increases. The same loose credit and
low rates driving US consumption steer Chinese
investment, Sovereign Wealth Fund placement and
world equity markets.
Each round of
effects acts like one in a line of falling
dominoes. Every step sets in motion the next.
Foreign earnings return to the US as asset
purchases. At the end of 2006, the US Net
International Investment Position (NIIP) reached
negative $2.54 trillion. This represents a $300
billion increase over 2005, a 13% larger negative
balance. America's NIIP declined despite
depreciating dollars and laggard US assets
returns.
High corporate earnings, loose
and abundant credit and upward redistribution
create bullish conditions for global equities and
bonds. Share buybacks have become a juggernaut.
Speaking to Reuters, Trim Tabs chief executive
officer Charles Biderman revealed that US firms
are buying back shares at a rate of $3.5 billion
per day. S&P 500 companies have spent more
than $950 billion on share repurchases since 2003.
Profits have been so strong that these firms
retain more than $600 billion in cash on their
books.
As funds, investors and bullish
attitudes target foreign companies, share prices
rise in tandem. This creates another virtuous
cycle. Returns attract inflows to funds that can
and do undertake bigger purchases. This generates
greater returns that attract more funds, and so it
goes. Until, of course, the music stops and some
are left dancing.
Private equity has been
involved in about 50% of merger-and-acquisition
activity in 2007. Concluded deals add up to $406
billion year-to-date. Buybacks and buyouts require
huge stockpiles of cash and cheap credit. The
individuals and institutions involved are flush
from redistribution. Huge amounts of capital are
available. Hopes run high and credit awaits the
asking. Regulations are few, global deals are
possible and paydays are enormous. Buybacks and
private-equity buyouts push up share prices and
remove shares from markets. This increases demand
and lowers supply in the same action.
The
effect and result of buyback/buyout frenzy is most
pronounced in the world's largest markets. Buyouts
and buybacks send flush investors with enlarged
holdings into other assets. Activity spills
quickly and easily across deregulated markets
dominated by multinational firms. US institutions
and individuals are buying ever more foreign
assets.
Price premiums creep into shares
around the world as hoped-for and realized buyback
and buyout internationalize. Greater risk equals
greater reward. This process sends risk-loving,
cash-rich speculators in search of new assets and
markets. Emerging-market shares and bonds have
benefited from this process.
The above
factors have combined to move assets into closer
correlation. This calls the potency of
international diversification into question. The
recent uptrend has been wonderfully broad. Many
have gleaned impressive returns chasing
emerging-market assets and buyout/buyback targets.
This creates the possibility that the necessary
follow-on correction will be similarly unusual in
correlation and breadth. We would expect a
downdraft to be differential in its impact - as
the updraft has been. However, we would also now
expect it to be anomalously correlated by
historical standards. Imbalance and monetary
largesse are essential boom ingredients and create
a tolerance - even lust - for risk.
We
advise keeping an eye on sovereign bond
interest-rate differentials, the rate and size of
private-equity deals, and emerging-market equity
performance. US housing and asset-backed
securities are already post-boom. We believe that
credit conditions will prove more difficult. The
challenge now is to understand and move ahead of a
possible correlated, international correction. The
likelihood of such an event seems to be growing by
the day. We expect some major trouble when
unusually correlated markets fall together.
Max Fraad Wolff is a doctoral
candidate in economics at the University of
Massachusetts, Amherst, and editor of the website
GlobalMacroScope.
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