Opinion

Reading between the lines

Finance | William Jensen | 27 Apr 2008

Who knows the outcome of the latest volume of the history of investment, asks William Jensen.

Having followed closely the pronouncements of central bankers, investment professionals and economists, I have come to the uncomfortable conclusion that only the delusional believe they can foresee the outcome of the current economic uncertainty with any confidence. That’s not to denigrate academic theory or practitioners’ experience, but an acknowledgement that we have passed the introduction and are well into the opening chapters of an adventure struc-tured around familiar themes but with significant new twists. It is Romeo and Juliet in the age of mobile phones, human rights and Facebook.

There are a few characters and sub-plots that are new to this drama. Let’s start with banking. It is nothing new to have each generation of bankers proclaim a new paradigm and declare the end of losses by the medium of superior credit management. By the same token, the current litany of provisions is a familiar cyclical tale. Arguably, what is different is the massive gearing of bank assets in this cycle and the potential of that and the interdependency of counterparty obligations to turn western economies into a dustbowl.

We are assured that US and European banks remain solvent, despite the scale of asset impairments, but tier 1 capital ratios are, in many instances, sinking to the lower thresholds as off-balance sheet SIVs and conduits have been given emergency funding, taken back onto the book or, in some instances, allowed to wither. As LIBOR rates returned to near normal in the first weeks of this year, it seemed that the liquidity crisis had been overcome. In recent weeks, it has re-emerged with a vengeance in the shape of rising margin calls on hedge funds, causing some of the most distinguished names to falter. None of this bodes well for early or sustainable recovery.

White knights often play a dramatic role in the familiar moral tale and in the global capital markets they ride under the banner of central banks. The tension that central bankers face in this drama between the need to pacify anxious investors with the balm of easy money and the growing threat of a secular turn in the inflationary cycle has intensi-fied in the last two months. Even the most trenchant believer in the death of inflation is hard-pressed to convince that the current trend in energy, raw material and agricultural commodity prices is but a transitory cyclical blip. Keep an eye on unemployment trends for the recessionary side of the equation and wage settlements for the inflationary forces.

And what of the strangers to this once-familiar tale? They come in the guise of confident, emerging economies where resources – human, land, oil and minerals – abound and where there is now a depth of political and economic aptitude that did not underpin permanence in previous cycles. We should welcome the momentum that these newly-confident political economies bring to the global markets but we should be under no illusion that Europe and the US are subject to a transfer of economic dominance with which will carry a penalty when its full ramifications are understood.

The thinking contrarian investor, much like the literary critic, will find opportunity in this tableau, but not necessarily where it is most expected. Tactical flexibility may also be a condition for successful outcomes, possibly over-riding strategic frameworks. The mispricing of some high quality debt may generate opportunities to capture equity-like returns, but with higher probability of delivery based on low default risk; rising energy and commodity prices may point to longer-term opportunities in the equity of generators, extractors and landowners, but not necessarily in the volatile arbitrage between spot and forward prices; and finally battered shares in companies that either have a strong presence in emerging markets or may become the targets of emerging market liquidity may be a better bet than the inflated and vulnerable emerging equity markets themselves. Expect surprises as you read your way through this volume in the long history of commerce.

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Who's Who: William Jensen