Outlook 2008

Global economy: between a rock and a hard place

Originally published in the December 2007/January 2008 issue

The world economy is expected to decelerate moderately in 2008 but the strong momentum of major emerging markets such as China and India will prevent a massive slowdown.

The US economy is skating on thin ice as consumer spending is likely to be curtailed by falling house prices, rising energy costs and stricter lending policies. The Fed is in a Catch 22 situation as it has to help consumers by lowering interest rates while simultaneously fighting rising inflation. It remains to be seen how the Central Bank will navigate this predicament. We do not expect a full recession in the US and think that emerging markets, which are less credit driven, will be able to offset a slowdown in the US.

According to the latest forecast from the IMF (IMF economic outlook 2008), global growth will slow from 5.2% in 2007 to 4.8% in 2008. Many economists lowered their growth forecasts in November, but most still expect moderate to strong growth outside the US. UBS, for example, has the lowest figure (4.3%) for global GDP growth during 2008. Hence, even the most conservative forecast is far above trend growth.

Emerging markets are now a significant part of the world economy, accounting for about 30% of global GDP at market exchange rates. This year, they have contributed half of global GDP growth.

Next year, it is highly likely that they will contribute more to global GDP growth than the G7, for the first time. Demand for products and services is likely to remain strong in these countries as consumers there are less reliant on credit, local currencies are relatively undervalued and most have lower budget deficits than developed countries. Fig.2 shows that the much talked about economic decoupling of Asia and the US has already occurred.

The current macroeconomic uncertainty suggests that equity markets will remain volatile for some time. With an average P/E ratio of about 15 times 2008E earnings, equities in developed markets are currently attractively priced if earnings hold up.

Despite the fact that the valuation gap between small/mid caps and large caps has narrowed, we expect large caps will continue to outperform with increased sector dispersion. In this environment, sector and stock picking skills will be paramount for long/short hedge funds as they can no longer rely on a rising overall market.

Relative value managers will face several challenges. Volatility arbitrageurs will benefit from a general long exposure to various levels of volatility and frequently shifting sentiment. Fixed income managers will look for opportunities in the yield curve that will arise from uncertainty around central bank action.

Steepeners (a trade that benefits when the yield curve steepens) will be well placed should central banks lower interest rates more than expected. Possibly, long term rates would not respond or might even rise due to stubborn inflation, which would result in a massive steepening.

Convertible bond arbitrageurs are likely to remain profitable, especially when realised volatility frequently exceeds implied, which allows more profits from gamma trading. New issuances could also help managers. A higher volatility regime is generally a good environment for new offerings. Within relative value, multi-strategy managers have the best outlook, as they have plenty of cash at hand and can quickly shift their investments to the most promising opportunities. For example, they recently moved their investments from CB arbitrage to FI arbitrage.

There are opportunities for both distressed and special situations in the event driven style. Managers focussing on distressed paper should have a larger playing field next year as the fallout from the credit and subprime crises will have to be dealt with. Some managers are now focussing on undervalued structured credit securities that were sold off during H2 2007. Many institutional money managers had to sell such securities when they were downgraded, often irrespective of their true value. Such forced selling often offers opportunities for specialised managers that have the capacity and expertise to analyse and value such positions correctly.

Classic distressed investing, shortly before or after a default, will remain limited as most companies in trouble are approached and restructured long before they actually default. Hence, the default rate as reported by the rating agencies will remain relatively low.

There are also some companies that are ‘walking wounded’, often due to covenant light structures that were granted during the height of the credit boom in H2 2006 and H1 2007. Such conditions allow troubled companies to avoid default, which explains the low default/distressed ratios (Fig.4).

After two boom years, announced M&A volume started to slow in H2 2007 as private equity firms, which dominated the scene in H1 now face tougher financing conditions. Nevertheless, 2007 has still been a record year. At the end of October, global M&A volume overtook last year’s record of USD 3.55 trillion. For 2008 we expect a lower, but still decent volume as strategic deals fill the gap. Many companies have large amounts of cash on their balance sheets and will be looking for external growth. Sectors such as mining, energy and insurance are expected to see further consolidation.

Sovereign Wealth Funds (SWFs) are also expected to increase their hunting ground as they are looking to diversify their huge foreign exchange reserves and fixed income holdings. According to the IMF, SWFs already manage US$2.5 trillion worldwide and this figure will increase rapidly. One recent example is Abu Dhabi Investment Authority’s US$7.5 billion cash infusion to Citigroup. Special situations managers will carefully monitor the future development of SWFs activities.

Fig.5 shows the fairly close relationship between M&A activity and GDP growth. Although the chart shows figures for Europe, the situation is fairly similar on a global basis.

The environment for global traders will remain challenging. The outlook for FX and fixed income is unclear and will depend on further data flow. The Fed is caught between a rock and a hard place as no matter what it does there is a high risk it will be wrong and there will not be a shortage of criticism. We expect inconsistent data flow will lead to continued high FX and FI volatility. The USD is set to rebound at some point in 2008 as the current overly negative sentiment may wane. A possible catalyst for a dollar rally could be when market participants realise that the ECB may also be forced to cut rates.

Carry trades will probably be unattractive for most of next year as elevated FX volatility will lead to a strengthening of the funding currencies, such as the JPY (see Fig.6)

US dollar reversal: The USD is undervalued according to purchasing power parity indices and sentiment is extremely negative. There could, however, be a sharp reversal when market participants realise the ECB and BOE also have to cut interest rates. Any narrowing of the US budget deficit and/or trade deficit could trigger a change in sentiment. As a result, some global macro managers are tentatively positioning themselves for a recovery.

Mis-priced credit: The massive downgrades of structured investment vehicles such as collateralised debt obligations, mortgage-backed securities and asset-backed securities have resulted in a huge wave of selling. Some managers are now looking for value as many of these securities may have been thrown out with the bathwater. For managers with the necessary skill set, this offers an excellent playground.

Emerging market local debt: Local emerging market bonds (sovereign bonds denominated in LC, not USD) continue to offer opportunities as many countries can now issue bonds in their home currency and build a local yield curve. Attractive markets include Brazil, Turkey and Mexico.

Domestic demand in emerging markets: Over the last decade, emerging markets have evolved into large consumer markets. They no longer just rely on export and cheap labour. While consumers are less debt-driven than in rich countries, they now have access to consumer finance and, increasingly, mortgages. This has fuelled domestic spending, making these economies more diverse and adaptable

Japanese reflation trade: Long Nikkei, long Yen, short JGB: A popular trade over the last three years which never really worked because Japan never exited from deflation. As a result the trade is not as popular, but it remains on the backburner.

Carry trade: The classic FX carry trade has been profitable for most of the last few years as FX volatility remained low and the Yen weak. This year, however, it has only worked partially and for 2008 it is expected to abate. Some managers are positioned to benefit from a reversal by being long JPY and CHF and short AUD, NZD or GBP.

Long Asian currency basket: Although Asian currencies have appreciated substantially over the last few years, they remain undervalued according to various measures. On a purchasing power basis (eg. Big Mac Index), Asian currencies such as MYR, TWD, IDR, HKD, TWD, CNY or JPY continue to look inexpensive.1

Food inflation: Continued growth of the global population coupled with rising income and higher living standards in emerging countries increases the demand for high protein food and grains. Many countries will have to rely on imports. At the same time, some crops such as sugar and corn are used to produce biofuel. This has caused a sharp rise in many soft commodities and pushed up consumer prices (especially in countries with a high share of food in the CPI).

New silk road: We expect the Chinese economic expansion to strongly influence the development of countries in central Asia. This region has not seen much development yet, but it lies between two prosperous areas (Middle East, Far East). Countries around the Black and the Caspian Sea, sometime also termed CIS (Commonwealth of Independent States) or FSU (Former Soviet Union) are not yet on the investment map but could emerge soon as frontier markets.

Carbon trading: Until recently, arbitrage opportunities between different energy markets such as oil, petrol or natural gas were based on assumptions regarding fundamental and/or political developments. With the introduction of the carbon trading scheme, these individual energy markets became more closely connected to each other, offering multiple trading and arbitrage opportunities.

Gulf region investing: The Middle East region offers a variety of compelling investment opportunities such as abundant domestic liquidity, strong corporate earnings, high consumer confidence fuelled by high and rising income levels as well as cheap equity valuations following the correction in 2006. Furthermore, the Middle East has historically shown low correlation to other regions and traditional asset classes outside that region.

The outlook for the energy complex is mixed. While the IEA (International Energy Agency) has substantially cut its 2008 demand growth forecast to 1.9 million barrels per day, non-OPEC supply forecasts are converging toward 1.0m million barrels per day for 2008 after a rise of 0.6 million barrels per day in 2007. Some analysts have been projecting a non-OPEC peak. The current market reality of very high oil prices reflects short-term tightness in global supply and demand, which could be reduced by technical selling at the beginning of 2008.

Looking into 2008 the environment for precious metals will remain favourable in general. Gold equites are very attractively valued compared to bullion. Within the industrial metal sector, supply disruptions and labour disputes are still a problem. However, weak demand from US housing should offset this somewhat. We expect prices to remain range bound for most of next year. With regards to managed futures, we do not expect a large number of strong trends. But this should be taken with a pinch of salt, as trends can sometimes emerge quickly and unexpectedly, thereby creating interesting opportunities for systematic CTAs.

In FX and FI there could be trends in either direction as rates and the USD may overshoot. The only real certainty for 2008 is that there will be a great deal of uncertainty. While we are reasonably confident that the global economy will continue to grow strongly, though at a slower pace than in the past couple of years, there may still be some shocks related to the credit market and it is unclear just how much trouble the US is in or what impact this will have on other markets.

In this environment we expect heightened volatility, with clear sector and market differentiation which should put the advantage firmly in the hands of skill-based hedge fund managers who have the ability to spot the opportunities and the tools to take advantage of them. 2007 has demonstrated that hedge funds are able to benefit from market stress, dislocations and heightened volatility.

1 MYR – Malaysian Ringgit, TWD – Taiwan Dollar, IDR – Indonesian Rupiah, HKD, Hongkong Dollar, TWD – Taiwan Dollar, CNY – Chinese Yuan Renminbi, JPY – Japanese Yen.