INVESTMENT TALK
By ROBERT ROUNTREE

IT would be nice if the good times kept rolling; they do not. The party “spoiler” inevitably joins the crowd. This job has traditionally fallen on the humble economist, whose job it is to water down the punch bowl just as the party is getting real good.

The global equities party is well under way and has, in fact, been on for four years. The “spoiler” has appeared, as if on cue, although it is too early for most partygoers to have noticed.

Ironically, the spoiler may decide that the time for an appearance is not quite right, and then exit the scene with scant notice. But at the moment, the spoiler is in the room. Whether this will be enough to undermine the party has yet to be determined. But we are at a critical juncture; a major reason for equity markets to embark on another correction is now in place should investors start looking for a convenient excuse to sell.

This begs the question as to why investors should want to sell in the first place if the longer-term outlook remains solid. Here’s the answer. We have consistently argued that although we think there is good long-term value to be found on a three-year time horizon, especially within Asia, short-term valuations are again at cyclical highs.

While markets are pretty efficient at pricing in short-term growth and potential, they are lousy at pricing in the longer-term. This situation thus creates times at which the short-term is fully discounted, but investors remain uncertain as to the value of the longer-term potential. They thus revert to selling, often aggressively, shaking out weak holders and “testing” the commitment of longer-term holders. If few sellers appear, or if buyers quickly reappear, then investors may feel that the longer-term potential remains intact.

This is a process we have written about several times, especially as we have seen it play out three times since the global rallies first began in May 2003 – and herein lies another story.

If one looks at the depth and duration of the three major bouts of selling that have punctuated the Asian rallies since May 2003, one notices two things; the sell-offs are getting progressively more shallow and they are also getting shorter. In other words, investors seem to be increasingly buying the longer-term growth story and are beginning to price in that potential. We could easily be building a “launch pad” from which to propel valuations higher.

This situation, however, probably opens the door to a final humdinger of a sell-off before valuations are pushed to new highs; investors want a final “test” before committing themselves to higher valuations. This is where the “spoiler” comes in. It stands to reason that investors could look for another reason to sell. If that reason has solid grounding rather than merely reflecting the “scare tactics” that lay behind February’s sell-off, then any resulting selling could be quite severe. This is what seems to be building up.

Few investors, for example, would be unaware that the world is awash in liquidity. This liquidity first found its way into bond and housing prices. Then, from May 2003, it was equities’ turn as investors recognised the low valuations of the time.

The record liquidity pool originally resulted from policies followed by many key central banks, most notably the US Federal Reserve Board and the Bank of Japan, which pumped money into their respective banking systems so as to offset the global economic slowdown that followed the bursting of the IT bubble.

Liquidity was subsequently created by other central banks which did not want to see their currencies appreciate significantly against a falling US dollar. They thus bought the dollar and sold their own currencies, which boosted domestic liquidity (unless the central bank “neutralised” this liquidity injection, which is what Bank Negara has been doing).

While the reasons how and why this liquidity appeared are complex, the important messages for the equity markets are not. A fair measure of this liquidity, for example, is absorbed by day-to-day economic activity and price increases. The liquidity that is left over generally ends up in equities after a time lag of around six to nine months. Put another way, changes in this “free” liquidity and equity market changes track each other closely.

In recent months, the situation has changed significantly – enter the “spoiler”. Although many central banks are still creating liquidity via their US dollar exchange rate policies, etc, etc, etc, the demand for money has risen, not only as economic activity has remained strong but also as isolated instances of higher prices have emerged. Thus, the huge pool of liquidity that was created after 2000 has not only been slowly depleted but is now contracting. Once this realisation hits the financial markets, the reaction could be explosive.

Under “normal” conditions, we would urge investor caution. But this time, that caution is tinged with two major caveats.

The first caveat is that as the global liquidity tide recedes, huge lakes of liquidity are appearing trapped in the “rock” pools. Japan is one of these lakes. This liquidity has been slowly seeping abroad in search of both higher income and value, seepage which has resulted in a yen that is far weaker than the economic data would otherwise suggest.

Much has been made of the hedge fund industry that has been borrowing the cheap and low yielding yen to invest in higher yielding offshore currencies. But to focus on the activity of this group of investors is to ignore the growing demand for value and yield emerging from the “Mom and Pop” brigade.

Japan, along with many other developed economies, has a pension crisis. The difference is that Japan also has a population “bubble” that is more advanced as people are increasingly joining the ranks of retirees. With the parlous state of Japan’s pension industry, many investors are increasingly looking for value and income abroad, which could very well ensure that the outflow of funds continues and the yen remains perennially weak. In short, Japan’s huge savings pool is showing signs of funding global markets and economies rather than those in Japan, a development about which many commentators are only becoming aware.

The second major caveat is that of valuations.

While short-term valuations are undeniably at cyclical peaks, valuations on a three-year view look cheap. In fact, one can make the case strongly that the global equity rallies seen since May 2003 have only removed the record low cheapness to which equities fell following the bursting of the technology bubble.

Equities have not, we can argue, discounted the strong global economic and profits growth that we are witnessing today. Put another way, global equities would have to rise some 300% (based on the consensus earnings forecasts) just for valuations to rise back to the peaks of 1980/81, 1989/1990 and 1999/2000.

So, even if the liquidity “spoiler” does its worst and equities enter a severe sell-off, is the party over? It does not look like it. As we argued last month, equities look to be extremely good value on a three-year (and longer) view. We reiterate; do not let the short term dust cloud the long-term outlook because that outlook is pretty good.

Rountree is head of investment marketing, Prudential Fund Management Services Singapore

NB: The views expressed above are those of the author and do not necessarily reflect those of Prudential Asset management.