Beware tailspin from false momentum

28 February 2011 | By Martin Gray

The correlation of movement across most asset classes steadily increased over the past 18 months and is higher than at any time since monitoring began, about 20 years ago. This is destroying asset allocation skills in portfolio construction. Risk management as analysis of copper versus aluminium, Shell versus Exxon, or gilts versus treasuries has become largely irrelevant - it is down to whether you are “in” or “out” of the market. Volatility has declined, as investors become comfortable moving up the risk ladder again.

Quantitative easing (QE) has achieved several things, but not necessarily the objectives it set out to. While the first round of QE might have had some success in reducing mortgage borrowing costs, this was reversed under QE2 as concerns over American debt levels pushed up long-dated yields. It is also causing rising inflation in those developing economies that peg or track their currencies to the dollar. However, the liquidity effect of quantitative easing is not trickling down to households or smaller businesses as intended, but into risk assets such as equities and commodities, especially in emerging markets, encouraging protectionism and stockpiling. (article continues below)

Asset allocation

Commercial property has kept a low profile in the investment world over the past year. Valuations of ultra-prime have recovered their pre-crisis highs, while banks have been quietly extending loan repayment dates and rolling over interest due.

But away from prime, things are likely to come to a head over the next couple of years, as the level of repayment/refinancing of deals, rises sharply. This will not be helped if long-term rates in American, European and British government debt markets continue to rise and non-prime valuations continue to wallow. The industry has estimated that there is about $2.4 trillion (£1.5 trillion) of real estate debt to mature over the next two years, of which the majority is in America and Europe. Banks have been working hard on rescheduling debt and selling down assets at the prime end of the market. However, there are many secondary assets to be dealt with, leaving foreclosures and substantial write-offs inevitable.

The surrounding “currency wars” or “competitive currency devaluation” centres on the struggle between the dollar and the renminbi, with China pushing America towards deflating its economy through its pegged exchange rate. In return, America is threatening to inflate the rest of the world, and China in particular, through infinite use of the dollar printing presses to try and force revaluation of managed currencies. America can win this battle even if the Chinese dig in, but the rest of the world and emerging markets in particular, will be the losers if this happens.

The yen is described as an over-valued currency, but while it may be against some of its Asian neighbours, it is difficult to make a case against the dollar and other western currencies. Since the yen was last at the current dollar exchange rate in 1995, the American inflation index has increased by more than 40%. Japan, meanwhile, has experienced bouts of chronic deflation and its rate of inflation has hardly changed, making this strong yen story difficult to justify.

Outlook

QE2 is the supposed American solution to its employment, growth and demand problems, but quantitative easing has already extended its reach to many emerging economies, which were not deeply affected by the banking crisis. Low interest rates in America and other first-world countries are increasingly causing strong flows of easy liquidity chasing assets in those emerging economies, where growth is looking potentially stronger over the coming years. As a result, exchange rate manipulation is becoming rife to stop currencies rising against the weak dollar. The fact that the hugely undervalued renminbi is linked to the dollar, is causing further pain, as it gives the Chinese an additional exchange rate advantage in the export markets. The danger is that we will start to see an escalation in retaliation in the form of tariffs, subsidies and trade barriers.

At some point, America will have to abandon its expansionary policy and start to think about a credible plan to reduce its huge accumulated deficit. It has been noticeable that each of the announcements of quantitative easing by America and Britain, as well as easy liquidity measures by Europe, have been followed by strong rises in asset markets around the world. But when liquidity and subsidy policies appeared to be coming to an end last April, markets fell back sharply only to recover when further quantitative easing and bank bail-outs emerged. It may need further rounds of ill-needed stimulus to keep the wheel spinning, but this is building up greater problems.

It feels as if a more cautious approach is warranted, especially since many investors who were loath to hold risk assets in 2009 and 2010 seem more confident to do so - just as they were in 2007.

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