Saturday, September 09, 2006

Financial Times Editorial - Back to work for the world's investors

Financial Times Editorial - Back to work for the world's investors
Copyright The Financial Times Limited 2006
Published: September 9 2006 03:00 | Last updated: September 9 2006 03:00

The houses in the Hamptons are empty, the yachts have returned to their moorings and the interns have been sent back to university. Now the worlds' fund managers and financiers are back at their desks, working out where to invest clients' money in order to generate the performance fees to pay for next year's summer holiday. The long, long boom in asset prices since the 1970s, which has driven many investments to vertiginous levels, means that is a difficult task.

After a three-year rally from the trough of 2003, US equities are within striking distance of levels reached during the internet bubble. Unlike the bubble years, these prices are supported by corporate profits: the S&P 500 index trades on a price-to-earnings multiple of only 15 times. This, however, comes far into an economic recovery. Profit margins and the share of profits in gross domestic product are the highest they have ever been, American consumers are showing signs of spending fatigue and interest rates may yet have further to rise.

There is always the possibility of a new paradigm. By putting pressure on wages, globalisation may mean that profits continue to take more of GDP. A global savings glut may have lowered the real rate of return required in the world economy. But new paradigms often turn out to be new ways to lose money. A new world of high profits and low real rates would surely mean a surge in business investment. That has not materialised yet.

While American shares look especially pricey, valuations are high around the world. Only in emerging markets, and particularly in east Asia, where traces of the 1997 crisis still linger, do some stocks look affordable. For foreign investors, east Asia has the further advantage of cheap currencies.

Though shares look expensive, bonds do not excite. Ten-year government debt in Britain and America yields less than an overnight deposit and Japanese government bonds appeal even less. Either deflation will resume and Japan will continue to run a vast budget deficit, or the economy will re-cover, deflation will end and real interest rates will rise. Japanese bonds will suffer in both scenarios. Nor do other bonds look compelling. The premiums paid by less creditworthy debtors - emerging market governments and highly leveraged companies - are still close to record lows.

But even in this world of expensive assets there are possibilities for investors. Not every asset is near its record high: Japanese property, particularly residential property, has only just begun to rise from levels last seen in the early 1980s. Another interesting area is implied volatility, the options market's estimate of how risky an asset is. For many assets it is the lowest it has been in a decade, but crises in the Middle East, a US trade deficit near 7 per cent of GDP and high commodity prices all suggest the world is still a risky place. There are possible explanations: hedge funds now provide more liquidity to the option markets, while central banks are more transparent, reducing uncertainty about interest rate moves. Investors, though, may still find strategies to implement through options that make them money.

Like children starting a new school year, investors returning to work will find the job has got a little harder. Making money with asset prices high and inflation low will be difficult. But for the investors that manage it, next year's summer holiday will be especially sweet.


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