Jul 4, 2007 Markets marching in step into trouble By Max Fraad Wolff The global equity-market surge is nearly four years old. Despite short, sharp swoons in the spring/summer of 2006 and February 2007, the trend is clear. Since 2003, global indices have surged. Emerging markets - represented by Morgan Stanley Capital International - in Asia, Latin America and Eastern Europe have moved upward in very tight correlation. The S&P 500, Nikkei 225 and Dow Jones Euro Stoxx have moved similarly and in lockstep. The past three to four years have seen a worldwide spike above trend. Markets have been "randomly" walking hand in hand. This reminds us of the recent global run-up in real-estate prices. However, the correlation is greater and price movements are more rapid. The past three to four years have also been marked by consistently loose credit standards and massive credit and monetary aggregate growth. Steady and low inflation has spread far and wide. Growth has been above trend, with no emerging-market region performing below 5% in 2006. In the period 2005-06, the emerging-market average growth rate in gross domestic product was 7% in constant 2000 dollars. Across the period 1960-2000, the average growth rate was 4.75%. Emerging-market bond spreads have declined by 60% measured against the 10-year US Treasury. Basic commodity prices have moved up and stayed elevated. These have been great times for growth and even better times to be invested in emerging markets. Returns in established markets have been Europe-led but strong in the US and Japan. Nearly everyone has been in grand equity-price expansion mode. Our interest centers on the high correlation and the drivers of recent events. We are concerned about correlation as it suggests potential for unusual risk as equity markets eventually return to earth. The drivers are clearly global. To position for rougher sailing in the right direction and the inevitable downdrafts, a basic understanding of the recent global run is required. Experience has starkly taught that unusual asset-prices correlation can cause real trouble when rising tides turn into receding waters. The LTCM saga, among several, serves as a reminder that unusual correlation can carve a swath of destruction through the best of models and assumptions. To what do so many owe their expanding fortunes? What are the new correlated vulnerabilities taking shape alongside the recent shared run-up? Financial deregulation and integration, exemplified by the merger wave in exchanges and financial firms, is a powerful driver. Capital is far freer to roam in search of returns. All market swords have two edges. Not since the years before World War I have international capital markets been so wide open. Technological and communication revolutions make the new freedoms far more rapidly actionable. The end of the colonial period - particularly after World War II - has produced many more independent states. They are now free to join the fray. This allows massively greater flows and centralization into larger funds. Sovereign wealth funds have swollen to more than US$2.5 trillion alongside massive pension, insurance, mutual, hedge and private-equity funds. Massive asset portfolios and newfound opportunities for leverage and movement buoy spirits and convince leading participants that they are the new masters of the universe. This attitude drips from the actions and speeches of finance personas in London, New York and beyond. The past decade is defined by large upward redistributions of wealth. The industrialized world, led by the United Kingdom and the United States, has seen rising income and wealth accrue to top percentiles. These are the folks who buy stocks and bonds, allocate to hedge and private-equity funds. The more of a growing pie they get, the more they spend on assets. Top marginal tax rates have fallen and capital controls have been removed. Capital-gains taxes have been cut and myriad ways around taxation have been found. The shares of national products going to corporate profits are around or above historic highs. The sheer wealth going to leading institutional and individual asset buyers is flabbergasting. The Merrill Lynch Cap Gemini 2007 World Wealth Report makes this very clear. Rapid growth in wealth and the population of high-net-worth (HNW) and ultra-high-net-worth (UHNW) individuals soared across 2006. Growth rates in the developing world were in excess of 10% across regions. By the end of 2006 there were 9.5 million individuals with $37.2 trillion in financial assets. Redistribution helps asset markets by creating a positive feedback loop between rising demand for and valuation of assets. Funds raise record cash in record time despite record numbers of hedge and private-equity investment options. Labor has fared less well. Money has been super-abundant. Central banks - led by the US Federal Reserve - have created vast quantities of cash. This cash sloshes around the world. The US runs massive deficits with oil and East Asian exporters. Americans globalize their easy monetary policy as vast export earnings for others. Hundreds of billions of these dollars enter exporter economies, increasing credit and purchasing power. Much ends up in official reserves. Not coincidentally, foreign-currency reserves have exploded since 2003. IMF Composition of Official Foreign Exchange Reserves data indicate that developing-country reserves grew from $1.6 trillion in 2003 to $3.6 trillion in 2006. Rising tides are linked as vast hoards of cash - born of loose monetary policy and trade imbalance - pass through global asset markets. As flows rise, upward pressure is put on asset prices and correlation increases. The same loose credit and low rates driving US consumption steer Chinese investment, Sovereign Wealth Fund placement and world equity markets. Each round of effects acts like one in a line of falling dominoes. Every step sets in motion the next. Foreign earnings return to the US as asset purchases. At the end of 2006, the US Net International Investment Position (NIIP) reached negative $2.54 trillion. This represents a $300 billion increase over 2005, a 13% larger negative balance. America's NIIP declined despite depreciating dollars and laggard US assets returns. High corporate earnings, loose and abundant credit and upward redistribution create bullish conditions for global equities and bonds. Share buybacks have become a juggernaut. Speaking to Reuters, Trim Tabs chief executive officer Charles Biderman revealed that US firms are buying back shares at a rate of $3.5 billion per day. S&P 500 companies have spent more than $950 billion on share repurchases since 2003. Profits have been so strong that these firms retain more than $600 billion in cash on their books. As funds, investors and bullish attitudes target foreign companies, share prices rise in tandem. This creates another virtuous cycle. Returns attract inflows to funds that can and do undertake bigger purchases. This generates greater returns that attract more funds, and so it goes. Until, of course, the music stops and some are left dancing. Private equity has been involved in about 50% of merger-and-acquisition activity in 2007. Concluded deals add up to $406 billion year-to-date. Buybacks and buyouts require huge stockpiles of cash and cheap credit. The individuals and institutions involved are flush from redistribution. Huge amounts of capital are available. Hopes run high and credit awaits the asking. Regulations are few, global deals are possible and paydays are enormous. Buybacks and private-equity buyouts push up share prices and remove shares from markets. This increases demand and lowers supply in the same action. The effect and result of buyback/buyout frenzy is most pronounced in the world's largest markets. Buyouts and buybacks send flush investors with enlarged holdings into other assets. Activity spills quickly and easily across deregulated markets dominated by multinational firms. US institutions and individuals are buying ever more foreign assets. Price premiums creep into shares around the world as hoped-for and realized buyback and buyout internationalize. Greater risk equals greater reward. This process sends risk-loving, cash-rich speculators in search of new assets and markets. Emerging-market shares and bonds have benefited from this process. The above factors have combined to move assets into closer correlation. This calls the potency of international diversification into question. The recent uptrend has been wonderfully broad. Many have gleaned impressive returns chasing emerging-market assets and buyout/buyback targets. This creates the possibility that the necessary follow-on correction will be similarly unusual in correlation and breadth. We would expect a downdraft to be differential in its impact - as the updraft has been. However, we would also now expect it to be anomalously correlated by historical standards. Imbalance and monetary largesse are essential boom ingredients and create a tolerance - even lust - for risk. We advise keeping an eye on sovereign bond interest-rate differentials, the rate and size of private-equity deals, and emerging-market equity performance. US housing and asset-backed securities are already post-boom. We believe that credit conditions will prove more difficult. The challenge now is to understand and move ahead of a possible correlated, international correction. The likelihood of such an event seems to be growing by the day. We expect some major trouble when unusually correlated markets fall together.