By Graham Macdonald
Managing Director of MBMG Group
Nominated for the Lorenzo Natali Prize
Four Horsemen of the Apocalypse - A Happy Ending?
Earlier this year, we wrote a treatise about the impending
problems facing the four fiscally-challenged ‘horsemen’ of the economic
apocalypse - Japan, USA, UK and the Eurozone). Today let us look at how
investors face incalculable financial risks alongside exceptional investment
opportunities and not necessarily in the most obvious areas.
The skewed relationship between danger and opportunity is evident in all asset
classes including currencies. Many readers have significant proportions of their
income and/or expenditure and/or liabilities (and in this sense any estate plans
are ultimately a form of contingent liability) in Thai Baht. However, other than
their own residential property and perhaps some bank deposits, many foreign
residents do not maintain significant Baht-denominated assets. Whether or not
they are fully cognisant of it, the decision to live in Thailand creates at
least a partial exposure to Baht on an individual’s liability and expense
account. Failure to take adequate Baht exposure to offset this increases an
investor’s risk. Should Baht weaken, an investor might not even be fully aware
of it. However, once this moves against them, e.g. Sterling’s collapse by around
1/3 to below THB50, the impact on lifestyle, purchasing power and effective net
worth suddenly becomes brutally evident.
The inevitable payback for the fiscal profligacy of all 4 horsemen will
massively increase such risks. All currencies will exhibit immense volatility at
different times. Any strength relative to Baht creates opportunities whereas
Baht strength is a risk of loss for holders of other currencies. These risks and
opportunities are even greater for higher Beta currencies such as Australian
Dollar which looks highly susceptible to a fall of between 10-50% in its
To avoid risk, investors should hold only assets denominated in or hedged to
Baht (or at least currencies correlated to Thai Baht). To exploit opportunities
investors need to manage tactical currency exposure to include currencies with
the best immediate term prospects of strengthening (writing today that would
seem to be USD, SGD and RMB but this highly changeable, fluid situation requires
active tactical management).
Similarly, investors also need to be very aware of the distorted risk/reward
metrics of underlying different asset classes right now, largely stemming from
the reduction of the RFR (the Risk-Free Rate or US 30-day T-Bill yield) to zero
in nominal terms. In real, inflation-adjusted, terms this currently equates to
an annual loss of around 3.5%. As all other asset return expectations derive
from the RFR, the need to take on greater risk just to maintain the real value
of money, has widespread implications.
Initially investors were forced to move up the curve into longer durations but
the crowding-out effect of this has seen the nominal return on two year T-Bills
fall to below 0.25% while even 10 year nominal yields have fallen to around 2%.
Even the nominal yield on 30 year T-bills has fallen to just 3.5%, which is
around break-even in real terms.
However, the longer term the debt instrument, the greater the risks:
* The primary risk in any debt instrument is that the issuer will ultimately
default or that the market will begin to price in default expectations at some
point (leaving investors the choice between realizing a potentially significant
loss or holding a riskier investment than originally intended). (Since S&P
downgraded US debt, money invested inflows have actually increased, largely
because markets, which already priced in S&P’s downgrade, assume Moody’s and
Fitch’s, despite their negative outlooks, won’t immediately follow suit. Also
the downgrade perversely caused institutions such as US pension to increase
exposure, replacing lower grade debt with T-Bills. To prevent a reduction in
average yields, these institutional investors have also found themselves
squeezed further along the duration curve. In a hypothetical case where S&P AA
is stipulated as a minimum average rating, then a permissible portfolio could
have previously consisted equally of S&P A rated debt and US sovereign debt,
averaging AA. However, after the downgrade the allocation needed to be adjusted
to maintain the average weighting. Rather than trying to replace the downgraded
US debt with other AAA debt (which is now somewhat scarce) it proved easier to
replace some of the lower grade A rated debt with re-rated AA+ US T-bills.)
* The second risk is interest rate risk which increases in line with debt
duration. A 30-year bond would lose substantial value between now and its
maturity date if interest rates increase at any point during that timescale. For
shorter term bonds or bills, this risk is far less.
So just to achieve even a break-even real return from T-Bills, investors have to
take on the significant risk of committing to 30-year bonds at a historically
low part of the rate cycle at a time when all three major ratings agencies have
negative outlooks. One direct result of such negative real yields has been the
greater interest in corporate debt and in emerging market sovereign debt
instruments which both appear more attractive credit risks than indebted
‘equine’ governments. However, the increased demand for these has also driven
prices higher and yields lower. Interesting opportunities remain; for example,
Indonesian debt should be on Baht investors’ radars because of the correlations
between the currencies. However, investors need to be aware of the risk of
spread blow-outs at the onset of the next crisis.
Investors are very much victims on the horns of a dilemma - the need to chase
yield pushes them to take risk, the urge to avoid risk costs them the
opportunity of positive real yield. Ultimately even income or low risk investors
have been forced out of fixed interest markets into equities, property and
While some attractive property yields are available, property investment values
in many jurisdictions right now, especially where any significant leverage is
used to ‘juice’ returns, are vulnerable to severe corrections and even the
entire loss of the amount invested. That is not to say that all property
opportunities are equally risky but rather that extreme care and discretion
needs to be exercised and in general we are not seeing attractive valuations or
yields yet in developed or western markets, which we fear have some way further
to fall from 2008 peaks.
Equities remain extremely correlated to global economic expectations and our
baseline forecast is for equity markets in general to correct in the region of
20-50% from current levels over the next couple of years. Equity valuations,
even after the recent correction, seem excessive within a global economic
framework that has been in recession for the most of the time since 2002 but has
hidden this through reliance on extreme government stimulus. Even fundamentally
attractive regions like ASEAN will contract in a severe global downturn although
the payback of debt in 1997 and relatively prudential macro management since
then has created an environment where recovery will come more quickly, and more
strongly, than in indebted nations and the trough will provide a spectacular
buying opportunity for regional stocks.
Commodities in general remain even more correlated to global economic outcomes
than equities. Tactical opportunities will, however, constantly present
themselves throughout the deflationary and recovery cycles but investors blindly
holding baskets of long commodities should expect to face extreme losses of well
over 50% at times.
Precious metals remain on an upward trajectory of late but with USD2000 per oz.
now in sight, the short term outlook faces some headwinds and possibly sharp
pullbacks are needed before bullion’s final attainment of a ratio approaching
1:1 with the DJIA. This could well see the Dow fall towards 1800 or gold
increase to over USD10,000 but the likeliest outcome is a rapprochement
somewhere in the lower/middle end of potential values. Gold mining stocks may
well outperform gold at various times in this unravelling.
Alternative assets can offer reasonable opportunities at the current time
although again investors need to be very selective - liquid, realizable
strategies such as managed futures and long/short equity are spaces to invest
whereas any mark to model schemes that rely on inflows to pay redemptions will
likely collapse altogether in this environment.
At times in the past a rising tide has lifted all boats - a falling tide will
create a few opportunities and a myriad of risks. Any hopes that all will be all
right in the long term via buy and hold or static asset allocations or
undiversified portfolios will almost certainly be dashed. Defined return
illiquid assets like litigation funding, student accommodation funds, traded
life settlements or any other creative accounting that relies entirely on mark
to model asset pricing will no doubt come crashing down around investors’ ears
with horrendous losses.
What is more, for both strategic and opportunistic investors the new environment
brings unbridled possibilities where money can be made in both rising and
The above data and research was compiled from sources
believed to be reliable. However, neither MBMG International Ltd nor its
officers can accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a result of any
actions taken or not taken as a consequence of reading the above article. For
more information please contact Graham Macdonald on [email protected]
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