Negative Real Yields, Sovereign Wealth Funds and Back to the Future

``Do what you will, this world's a fiction and is made up of contradiction.”-William Blake (1757-1827), English Poet, Printer and Printmaker

True enough the uncertainties in the US financial system and its economy is duly a cause of concern which again is likely to impact the interim direction of our markets. However, we do not share the sudden resurgence of the “recoupling” argument.

In the world of financial globalization, integration is the byword, or in essence, markets and economies are expected to “couple” relative to cross border capital flows, trading and other economic activities and in the financial markets. But the diversity in the structures of the economies or the markets or of policies or a combination thereof is unlikely to produce a perfect integration. The “Dry Bone” inference of the foot bone is connected to the anklebone is connected to the leg bone is connected to the hipbone etc… signifies oversimplified thinking.

For instance we have long argued that monetary policies have had in the recent past served as an important influence to global asset classes. While it may be also accurate in the past that the “when the US sneezes the world catches cold”, past performance may not be an accurate indicator of the future.

This important quote from Dr. Marc Faber, ``Moreover, it would be wrong simply to assume that recession and slumping corporate profit will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed fund rate, a weak dollar, and “bubbly” emerging markets could make US equities a relatively attractive proposition compared to other financial assets.”

One can just take a glimpse of the bourses of the Gulf Cooperation Council which appears to have decoupled from most global equities in view of their exploding performances. Why? Because of the monetary regime -a US dollar peg, which has effectively tied their domestic policies with that of the US.

The declining US dollar have in essence imported inflation into these countries teeming with surplus foreign reserves which seems to be giving investors a one way bet in anticipation of a break of the currency peg. Where the underlying inflation rates are greater than nominal policy rates redound to negative real yields as described by Dr. Faber.

In short, central banks can control the money they print but they can’t control where it goes. This leads us to the recent breakaway run in gold prices amidst the deflationary backdrop in Anglo Saxon economies shown in Figure 4.

Figure 4: Prieur Du Plessis/Plexus Asset Management: Rampaging Gold Prices in Various Currencies

Gold has not been rising based on the US dollar alone, but against almost all major currencies as shown in the above chart courtesy of Prieur Du Plessis.

And you think oil’s $100 milestone high is all about demand and supply as academic “know them all” experts tell you. Check out Figure 5.

Figure 5: stockcharts.com: Falling US dollar Index and Rising Oil prices!

For over two years the peaks and troughs of the US dollar and the Oil prices appears to have been “perfectly” synchronized (green arrows); each time US dollar peaks oil bottoms and vice versa. This simply suggests that a decline in the value of US dollars, the currency from which oil is predominantly traded, has likewise prompted a rise in oil prices. In short, oil prices, aside from demand and supply, simply reflect on the relative declining value of the US dollar.

If gold, oil and the GCCs are manifesting a departure from the “recoupling” theme, why shouldn’t emerging markets?

Our views have almost been isolated given many apostasies among former decoupling advocates, except for one, incidentally a favorite…BCA Research,

Figure 6: BCA Research: Emerging Market Decoupling to Persist into 2008

According to BCA Research (our emphasis), ``The economic decoupling between emerging economies and the U.S. is attributable to underlying fundamentals and is therefore sustainable. Unlike in the 1990s when emerging economies relied on foreign capital to finance their expansion, many of these countries are now net creditors in global financial markets and are not vulnerable to a withdrawal of financing by G7 banks. Domestic interest rates are still very stimulative thanks to their strong currencies and vast savings, which will continue to underpin domestic demand growth. While exports to the U.S. have been slowing, trade among developing economies is booming. As a result, overall emerging market growth will not slow considerably, even if the U.S. economic slump continues. Bottom line: Our Emerging Markets Strategy service recommends that investors continue to overweight emerging equity markets within a global portfolio.”

True, as net creditors emerging markets via Sovereign Wealth Funds armed with an estimated $2.5 trillion of investible funds and assets, have been on a buying spree for distressed US assets and elsewhere around the globe…

From Bloomberg’s Zachary R. Mider (highlight mine), ``Foreign investors exploited the declining U.S. dollar during the past three months to snap up American companies at the fastest pace in at least a decade. Buyers from Dubai to the Netherlands accounted for 46% of the $230.5 billion of U.S. mergers and acquisitions announced in the fourth quarter, the biggest share since 1998 when Bloomberg started compiling the data. The total excludes $17.9 billion of so-called passive investments by state-run funds in Asia and the Middle East in U.S. banks, including New York-based Citigroup Inc.”

From Telegraph’s Ambrose Pritchard (highlight mine), ``Abu Dhabi's giant fund Adia ($875bn) rescued Citibank with a $7.5bn equity infusion, taking advantage of the US mortgage crisis to scoop up 4.9pc of the world's top bank for a pittance…

``The modus operandi of the funds is to dip their toe in the water, then build up a strategic stake gradually if all goes well. Temasek has taken a 2pc share in Barclays, while China's Development Bank holds 3.1pc - a stake that may be in doubt after Barclays' failed bid for ABN Amro.

``Dubai's various state-controlled bodies hold 2.2pc of Deutsche Bank, 3pc of HSBC, 3.5pc of Euronext, 2pc of Perella Weinberg Partners, 28pc of the London Stock Exchange, 20pc of Nasdaq and 68pc of Thomas Cook India.

``Abu Dhabi has pushed its stake in Mid-East banks to 30pc or 40pc, or even 97pc in the case of BLC Bank in Lebanon. Whether Western countries will tolerate strategic creep of this kind is another matter.

From S&P (highlight mine)…

``Temasek Holdings, based in Singapore, has equity in a range of banks, including Barclays, Standard Chartered, China Construction Bank, DBS Bank, ICICI Bank, and Sberbank.”

Thus would it be a wonder why perceptions on emerging markets have encountered a remarkable makeover?

This from Dow Jones’ Charles Roth and Claudia Assis (highlight mine)… ``Traditionally, investors would scramble from emerging markets at the first signs of trouble within the asset class or in response to global market volatility and tightening credit. But after four straight years of big annual gains, 2007 became not only the fifth year of clear outperformance but the first in which emerging markets became something of a safe haven from the implosion in the U.S. subprime mortgage market and the subsequent fallout…”

Deflation advocates claim that Sovereign wealth funds will simply deplete their surpluses by throwing money after bad assets. The assumption is that these state owned funds (state capitalism-Brad Setser) would function like unthinking zombie investors buying up US assets which will continue to collapse. Maybe, but seems quite unlikely if not outrageous.

From the Financial Times (highlight mine)… `` A secretive Hong Kong-based subsidiary of China’s State Administration of Foreign Exchange, manager of the world’s largest foreign exchange reserves, has bought stakes in three of Australia’s largest banks, raising fresh questions about transparency of China’s sovereign wealth investments in international markets.

``Australia and New Zealand Bank and Commonwealth Bank of Australia said Hong Kong-registered SAFE Investment Company had bought stakes of less than one per cent in each of the banks. An entity with the same name has taken a stake of about one-third of a per cent in National Australia Bank , people inside NAB reckon.”

It is no doubt why such level headed fund managers believe that emerging markets are still likely to outperform US markets despite the present juncture.

Lastly over the long term, the present divergence is likely to be a representation of a continuing transitional shift in market leadership, see Figure 7 courtesy of Chris Gilpin of Casey Research…

Figure 7 Resource Investor/Casey Research: Shifting Market Leadership

From the S & P 500, the market leaders had been energy and basic materials in late 70s to technology in the late 90s to financials into the new millennium… Are we seeing a shift back to energy and basic materials? Back to the Future?