Business Times of 05 July 2006

By JOSEPH CHONG

IT IN OUR internal investment strategy paper for 2006 (excerpts of which were published in BT on Feb 8), we predicted that 2006 would be a tricky year for managing money - contrary to the optimistic consensus then.

Compared with underlying GDP growth, emerging equity markets are volatile. Various explanations have been proffered. I am of the view that there are two main reasons for this:

• The pool of domestic funds is relatively small. Most emerging economies are net foreign debtors (Brazil and Turkey have foreign debts of 50-70 per cent of GDP). Even investible funds held by locals are often held as US$ or other G-3 currencies. These markets are therefore reliant on foreign portfolio flows.

• Emerging equity markets are small relative to the universe of global markets. Latin America plus Asia ex-Japan and Australia make up only 3 per cent of the global market capitalisation. To make a meaningful impact, asset allocators need to move over - and underweight positions by at least 3-5 per cent. In the case of Europe, which has a 30 per cent global market cap, this would not be very significant. For emerging markets this constitutes either doubling or nothing. Emerging markets are like a small bathtub - even a small child could cause major changes in the water level.
 

The above reasons imply that valuations per se are not a very effective timing tool for buying or selling in emerging markets. The broad swing in valuations appears to be a manifestation of foreign liquidity flows. These liquidity flows are, in turn, a function of monetary policy in the G-3 (the US, EU and Japan).

Until recently, the primary source of liquidity directly or indirectly has been Japan's zero interest rate policy or ZIRP. Oddly enough, to profit from the swings in emerging markets one needs to understand the US Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BOJ). Some have lamented this as latent economic imperialism.

About three years ago, the talk was all about deflation - US and Europe following Japan's example. Today, with core inflation in US, Europe and Japan back to 0.5 per cent and 2 per cent (very modest and healthy numbers) there appears to be hysteria of pessimism about stagflation, etc.

Most media reports have incorrectly ascribed the equity market negativity to the appearance of slightly higher US core inflation data as 'fear of inflation'. We say 'appearance' because, upon closer scrutiny, the data is really not bad. The core index, excluding food and energy prices, rose 0.3 per cent in April. The increase was 0.294 per cent before rounding, down slightly from the 0.344 per cent increase in March.

Shelter accounted for about one-half of the increase in the core CPI in April. Shelter costs surged temporarily because people were not buying homes because of the falling housing market but renting instead. Ten-year US Treasuries actually rose in value - that is, yields fell after an initial spike to close at a low after the release of the CPI data. Yields should have risen if inflation had been a concern.

Fundamentally, inflation is a well-known lagging indicator of economic cycles. It tends to peak or trough 2-3 quarters after the top and bottom of the business cycle. Therefore, it always looks a little like stagflation at the top of the business cycle. Moreover, the rise in core inflation is not being caused by increases in wages. Other income indicators confirm the virtual absence of pernicious wage-push inflation.

Is it possible for companies to raise prices when workers, who are not getting big pay increments, cannot afford higher prices?

What the equity market is fearful of is a central bank over-reacting to the inflation data and inducing a recession in the US. The Greenspan premium is gone and there appears to be a Bernanke discount. Indeed, the New York Post headlined one of their stories after one of Bernanke's speeches, 'Blundering Ben'.

Unfortunately, lack of confidence in Bernanke has raised the cost of capital for firms worldwide by increasing equity risk premiums. Thank goodness the Fed chairmen need to be reappointed every two years.

Things appear to be looking up for the domestic residential property market. It is that old story: supply and demand. According to URA data, unsold inventory has fallen from about 25,000 units two years ago to 15,000 last year and about 11,000 currently (about 15 months of sales). Vacancies have fallen from 8.8 per cent a year ago to 7.4 per cent currently.

However, the appreciation in house values appears to be concentrated in the prime Districts 9 and 10. Indeed, this is what we expected in 2004 in our BT piece of Jan 16, 2004 ('The way to go in property investment'), albeit the pace of appreciation has surprised us.

We came to this conclusion from a valuation model which we developed in-house and published in 2004 (readers can access this at our Web page http://www.ni.com.sg/newsletters.asp). The core insight is that there are two parts to a house: the buildings, and the land. Buildings depreciate with time - that is, get consumed. Land tends to appreciate at the rate of GDP growth per capita - less any lease depreciation. A home in the prime districts therefore would retain value better as the 'land content' is greater.

Moreover, there are hardly any more large plots of undeveloped land and the State cannot reclaim land in the prime areas. Supply is therefore constricted. Demand, on the other hand, for prime districts is always growing. The primary source of new supply is therefore more intensive use of redeveloped land - that is, en bloc redevelopment. Should this be restricted by the authorities, the supply shortage will tend to drive out performance of the prime areas relative to the suburbs.

This is what investors like: heads, I win; tails, I also win.

The author is CEO of financial adviser New Independent. He welcomes feedback at josephchong@ni.com.sg This article is for information only. Readers should seek independent advice before making any investment decisions.