Downturn = Opportunity?
Nagaswami took the audience through a detailed presentation covering global equity, debt, housing, and currency markets. The reason for her optimism, at the risk of oversimplifying, is that investor sentiment has caused certain segments of the market to become too cheap, creating opportunities for patient, disciplined investors. She cited three key pockets she believes are particularly rich with bargains, though she was careful to say that one still had to be ve
ry careful of "value traps": financial services equities, investment grade corporates, and corporate high-yield debt.
Flight to Safety Creating "Unsustainable Situation"
Nagaswami argued that the impact of the US housing crisis is lower than many think, and the linkage of the US economy to emerging markets is also less than is typically thought. Nevertheless, she said, investors have panicked, selling out of equity funds and moving into cash at a high rate, and bidding up credit spreads to abnormal levels: "We have reached the realm of absurdity. Certainty is so prized . . . that the real yield at short end of global bond market is negative. This is unsustainable. In the UK, real yields are at lows we haven't seen in a very long time."
Conversely, Nagaswami said that investors have sold down credit risk so sharply, that yield spreads over government bonds have now reached equity-like risk premiums, up from a mere 75-90 basis points not that long ago. "Today--the price of risk has soared, with now the price of risk in bonds approaching levels that one expects to see in equities, and without the risk of equities. In this flight to safety, investors have discarded the worthy with the unworthy. Corporate high-yield and investment-grade corporates today represent some of the most remarkable investment opportunities that I have seen in my career." Moreover, Nagaswami argued that the default risk doesn't appear to justify such pricing--she characterised defaults as "rather low," and said that although she expects they will rise, she doesn't think they will rise to the level that is implied by the yields being offered.
Subprime Crisis Not Threat to Global Financial System
With respect to the subprime crisis, Nagaswami argued persuasively that it was not a threat to the global financial system. She put the net after tax impact of defaults at $275 billion, noting that this was about 6% of the $4.5 trillion book value of global banks coming into the crisis. She argued instead that with central bank intervention and banks' strong capitalisation levels and ability to raise capital in global markets, she expect the impact to be mostly over within a year, and not something sizable enough to truly harm the global financial system.
UK Housing Due for a Rough Ride
Nagaswami also touched on the UK housing market. She noted that consumer debt was high, with mortgages representing about 28% of disposable income, compared to just 19% a few years ago. She also said that she believed a 20% decline in nominal housing prices was possible over a 1 - 2.5 year period. Nevertheless, she thought the crisis would not be as severe as that of the early 90s due to substantially lower interest rates. In comparison with the US market, she also argued that the UK may prove more resilient given that the housing supply is much more constrained here--in the US, there is an oversupply of roughly 10%, whilst the figure is closer to 2% in the UK.
Stay the Course
In closing, Nagaswami made a key point that we believe all investors would do well to listen to, but it applies particularly those who are moving out of the market and into cash in an effort to protect assets: Trying to time the market may well harm you much more than it will help. The data she used to back this up are persuasive: Over nearly 40 years, she noted, global equities have returned an average of roughly 0.90% per month. However, in 90% of those months, returns were essentially flat. In just 10% of them, the average return was 7.5%. The point is that, "Returns come in episodic bursts. Sitting on the sidelines risks missing these periods. It is the worst thing we can do for our clients--we need to calm down our clients and keep them invested." We couldn't agree more.
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