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Li says the subprime marketÆs troubles have been long anticipated. He says the current crisis is a useful reminder that risk always exists in capital markets, but will not threaten the underlying strength in the world economy.
The subprime crisis is not over, of course, as the market craves more information about the balance sheets of investment banks and commercial banks, which have begun reporting this week. But so far the crisis has played out according to plan: exposures appear to be spread widely enough so that, while some small banks or hedge funds must be closed, no major financial institution has suffered a crippling loss.
An important trend beneath this spreading of risk is an overall decline in economic volatility, Li says: ôThereÆs evidence to show the world in economic terms has become more stable, with stronger corporate balance sheets and profitability.ö
He looks at data from the United States that goes back to the 1940s to make his case. Looking at GDP growth, inflation and corporate profit growth in the post-war boom (1946-68), the high-inflation period of 1968-84 and the period of stability ushered in by Paul Volcker and Ronald Reagan (1984-2006), he finds that all of these indicators have fallen. US GDP growth has slowed, inflation has fallen, and corporate profits have come down (although these bucked the trends in the 1970s when profits were very high).
Within the US context, Li believes the main factor is the diversification of the US economy. Five sectors dominated the US economy in the post-war era, defence, inventories, residential investment, goods and trade. All of these have declined as a share of US economic activity. Defence spending, for example, contributed 20% to US GDP in the mid-1950s; today itÆs 4%. So while individual sectors such as defence spending have been volatile, their impact has been diluted.
This is a global, not a US, event, Li believes. The United Kingdom, Germany and Japan have witnessed similar declines in volatility of GDP growth. ôThis trend will continue so long as globalisation continues,ö he says, noting the biggest risk is a rise in protectionism.
GDP growth is not the only phenomenon that has become more predictable; so has inflation. This is part thanks to central banksÆ improved vigilance, but it also reflects the diversification of consumption. For example, in the post-war era, food accounted for 26% of consumer spending in the developed countries. Today itÆs 14%. EnergyÆs share nearly halved from 4.6% to 2.4%.
Does the same hold true for emerging markets? Li acknowledges the data is too thin to say for sure. ôBut this is generally a global trend,ö he argues.
Today, on the back of greater stability is heightened confidence, which is supported by high levels of corporate profitability and creditworthiness. This has been reflected in tight yields in credit bond markets.
For example, single-B rated corporate bonds in the US yielded on average 1,075 basis points more than US Treasuries in 2000 at the height of the tech bubble. Spreads proceeded to compress to 260bps in June 2007; theyÆve since widened out closer to 450bps, which looks like a big jump, but the overall level of the market is not going to head back to 2000 territory. Yields will remain low because of the stability of economic growth, strong corporate profits and good credit ratings, which mean less risk.
It was this reduced level or risk that drove many investors into high-yielding instruments including CDOs backed by subprime mortgages, with exposures often leveraged. The subprime crisis has served notice that reckless investments are dangerous û risk does exist.
The subprime market crisis has created a panic because of the lack of transparency, which has hurt confidence. But Li believes the subprime mortgage sector is small enough û and losses can still be recouped through foreclosures û that the economic damage will be limited.
Nonetheless the crisis has hit equity markets, particularly in emerging markets. The US stock market, ironically, has suffered relatively little. But thatÆs because emerging markets remain less diversified. Li points out that the top 25 largest stocks in America account for 34% of its total market capitalisation, far lower than in markets such as Taiwan (72%) or Hong Kong (90%). Moreover, the US marketÆs diversity makes it resilient; if one sector such as financials is suffering, another such as tech is performing well. Emerging markets tend to be too dominated by a single sector.
The lesson from the US and the Western developed world has been diversity leads to stability. So for long-term investors today, the best defence against havoc wreaked by the subprime crisis is to be diversified. And despite the higher volatility among emerging markets, this is where AllianceBernstein remains overweight, both for growth and for value.
Valuations in Bric countries may appear high, but Li says this is justified by these economiesÆ greater potential for growth. ôEmerging markets are in a phase of huge, multi-year capital spending,ö he says.
So is this a time to be cautious about riskier emerging markets, or to buy? ôWe know the subprime crisis is a US event,ö Li says, ôand there is no subprime market in the emerging world. We always view volatility as an opportunity.ö
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