Sunday, February 14, 2010

The Party is over, No More Free Rides

Downunder Daily Reconsidering the Set-back

Quick Comment:
We didn’t expect a setback to risk assets so soon in 2010. We’re still not convinced that this is the ‘big one’ – we expect a 20%-plus peak-to-trough decline in developed equities some time this year – but we’re learning to be less dogmatic about that. Here are some thoughts:

First, correlation is back. We had thought that there would be more diversity in returns this year, but risk assets have again been highly correlated (Exhibit 1). There’s been nowhere to hide. To be fair, this is partly because there’s been adverse news on a broad front (sovereign stress, Chinese tightening, financial sector taxes and/or re-regulation).

Second, the equity performance pecking order remains unchanged. Those markets that did worse in 2008 did best in 2009 and have done worse (again) this year (Exhibit 2). There have been a few outliers, but they are easy to explain (no surprise, for example, that Spanish and Greek equities have under-performed).

This suggests that most investors now hold their views (and positions) with low conviction. After a cycle where the unthinkable happened, it seems few are willing to stand in the way of a sentiment shift. This will make for fast, flighty markets for some time. Nimbleness will be
important, even if, for now, discrimination is not.

It also suggests that low-conviction investors are playing by the standard rule book even though, in our view, the rules should have changed. So, for example, seeing Asia as the high-beta play on the global growth cycle ignores the fact that one uncertainty from two years ago is now gone. We now know how Asia would cope with a western-world downturn: it coped well. Asia passed the 2008 crisis not unscathed, but in sound structural shape.

That matters: we think a new synchronized globaldownturn remains unlikely. It also suggests that Asian equities (and EM generally) should do better than DM on a medium-term view.



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