What a difference a couple of days make. Last week, markets were looking rather flattish. Then it picked up noticeably over the last few days. Patience remains the key here. Every time markets retreat a bit, there is always the fear whether it will go further south. I tend to handle it by asking myself whether fundamentals have changed, and what might derail a recovery. If I don’t, then I may actually buy more when markets dip.
In any case, so far, I am not seeing it. Yes, investors worry about what happens when the stimulus packages end, and every so often, you hear what if we get a double dip recession. But you have the world’s leaders here in APEC essentially saying that they are still very much concerned about the health of the recovery, and so, they will be careful about any exit strategies.
Most Asia companies had much stronger balance sheets than US ones, and other than having to deal with the drop in demand, which is now gradually recovering, at least most Asian companies did not have to also deal with having to refinance debt in a debt market that was frozen the way the US debt market locked up. Now, the worst is essentially over, and Asia is rebounding in a big way. While demand from the US is likely to recover slowly, other parts of Asia including China will step in to make up for it. A report issued this week confirmed what most of us already guessed. Trade within Asia has been growing. Its not an overnight change, but as intra-Asian trade continues to grow at a faster rate than external Asian trade, then we will be in a better position to pick ourselves up and recover from the recession simply because within Asia, trade activity is still increasing rapidly. Hence my confidence that we don’t need US’s economy to roar back in a big way just for Asia to continue growing.
Of course, even on that point, things are not that bleak. US consumer confidence hit rock bottom this year. As we move into 2010, things will look better. Measured against the low base that is the year 2009, most economic indicators and company earnings are likely to look good.
Within such a recovery backdrop though, there will continue to be concerns, and in Asia, asset bubbles are a danger to watch for. The low interest rates and stimulus packages have created a lot of liquidity, and a lot of it has flowed into Asia and emerging markets. If allowed to get out of hand, when they do burst, it will be very painful.
Because of this, I continue to do some hedging by holding my precious metals fund and my Russia fund. Commodities and oil are the weak Achilles heel of Asia because we generally have to import a lot of it. If its anything that could stop Asia’s recovery, it would be if price speculation pushed up such prices beyond their fundamentals. Hence, having some exposure into these would ensure that if this unhappy situation does come to pass, at least some of my funds will be making a lot of money.
Another area I am hedging within my portfolio is my exposure to bond funds – namely emerging market bond funds and high yield bond funds. At this point, I find it difficult to justify placing much money in fixed deposits, or even investment grade type bond funds simply because these are either earning really low interest, or are likely to be sensitive to a rising interest rate environment. Emerging market bonds and high yield bond funds are much less sensitive to that.
Also, it is a way to hedge against the scenario where the global economy goes sideways. I don’t see this as likely, but what if speculators drive up commodity prices so high that rising costs cuts into the profit margins of most companies in a big way? You can only pass on so much rising costs to a consumer that is already price conscious in the current environment. Or some other unforeseen event that doesn’t quite cause another recession, but results in little to no growth over the next 2 years.
In that kind of situation, high yield bonds and emerging market bonds would be my hedge. In the high yield bond market, many companies had already managed to refinance themselves for the next few years, and as long as they can meet their current interest rate obligations, they are unlikely to go under. The surprising thing is that we haven’t quite seen the number of bankruptcies that we expected to. The biggest example, during the great depression, over 3000 banks went under in the US, but up till now, less than 150 banks have been taken over by US bank regulators this year.
Its one year already since Lehman Brothers collapsed. If we haven’t seen a big round of company failures up till now, then, in a gradually improving environment, we won’t be seeing it either. Yet, interest rate yields for high yield bonds remain significantly higher than for investment grade bonds, when the very high possibility of interest rates going up eventually over the next 2 years is going to have a much more negative impact on investment grade bonds than high yield bonds.
Many emerging market bonds also remain at higher yields compared to the developed country sovereign bonds. This despite the fact that in today’s world, it is clear who are the major creditors and who are the major debtors. There is a disconnect here that is not going to change simply because rating agencies are used to giving emerging market bonds a higher risk premium. Yet, I ask myself. Who is in greater danger of defaulting on interest payments? An emerging market country which has strong foreign reserves, is growing fast, and is exporting either lots of goods (like China) or exporting lots of commodities (like Brazil) and is a net creditor, or a country that doesn’t have much reserves, spends more than it earns (has a big deficit), and is a net debtor. I think I can fit lots of developed countries with strong investment grade type ratings into this latter category. Yet, a lot of emerging market bonds continue to give a higher yield compared to the developed countries.
So, I remain highly positive, and I am looking forward to a next phase of market uptrend over the next 6 months to one year. In the meantime though, I am taking pains to hedge by having exposure to oil (through my Russia fund), precious metals, emerging market bonds and high yield bond funds.
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