By Cees Bruggemans, Chief Economist FNB
02 November 2010


Many of our institutional investment managers and business managers across a wide range of industries, and even our hands-on policymakers have one thing in common.

Skepticism.

It is a serious business, making or losing money. For that reason alone one tends to be glued to the coal face, intensely examining daily data flows and other entrails, and looking sideways at competing management and investment teams for confirmation.

How safe is it really? How far can one really go? Surely one shouldn't wander too far off the reservation, away from the herd, enveloped in the cold lonely embrace of isolation and being out on a limb?

It is often better to be wrong together with your peers than to be right but out on a limb. That's what emotion, belonging and coziness do to you.

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Internationally, it is an article of faith that emerging countries are more risky than developed ones.

Thus home bias and skepticism have kept global investment portfolios heavily geared to developed rich country markets.

As recently as the 1982 Third World Debt and the 1998 Asian Contagion scares those views paid off handsomely.

Thereafter, however, the world fundamentally changed but mostly forgot to inform institutional investment managers until reality upended all coziness.

It turned out that for 30 years increasing debt leverage and especially the breezy last ten years of this craze had made the developed rich world deeply risky, and biased to heavy underperformance during the subsequent ten years of painful workout.

In contrast, constrained leverage of emerging countries and commodity producers, and their innate growth dynamic only now fully blossoming, made this half of world GDP much less risky than long billed, and potentially a long-term outperformer.

But instead of global institutional investors massively repositioning their portfolios, there is only a minimal shift underway, and this taking years to effect.

Certainly the changing flows into emerging countries in absolute terms today are impressive, even causing talk of currency 'war', but in relative terms global portfolios are only shifting glacially.

And the reason? Deep skepticism only changing gradually, herd instinct suggesting the slow coach, because you may never know what you have missed risk-wise, and it is better to be wrong in good company ('what are your peers doing?') rather than find yourself on your own.

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In South Africa, such herding and slow moving is also a very old phenomenon.

With the Rand already on a two-year firming streak, with global forces promising at least another two years of currency strength (if not much longer) if nothing is done locally to undo this, institutional portfolios are apparently on average only 12% invested overseas, compared to prudential limits of nearly twice that size.

Theoretically, everyone today should be filling his/her boots with global exposure against the possibility of the cycle again turning sometime.

Two arguments are against this.

Firstly, the Rand may firm a lot further, so it is early days (thinking you can pick the moment exactly).

Secondly, what do you buy, for developed asset markets may offer poor value and a long period of hard times, while other emerging markets will be correlated with ourselves, not giving us the real benefit of asset diversification?

Fair enough, stick with the devil you know rather all the unknowns abroad, even if the daily advice is to diversify for it has proven itself in the long run.

But this does not undo another phenomenon, namely preferring to be heavily in cash compared to being more fully invested, especially in bonds but also equities.

Our institutional managers holding bonds had certain performance objectives (yield/price targets) in mind as this latest asset boom rolled into town.

Such targets were enticing, but not necessarily particularly challenging when measured against a REAL global boom.

It then turned out reality was going to be a lot more richer than ever imagined, foreigners invaded on an unprecedented scale and values went ballistic (at least in institutional minds, not expecting quite SUCH liveliness to come ashore here).

But instead of opportunistically moving the goalposts as the boom transformed reality, many investment managers got stuck once they had achieved their by now old comfortable targets and started selling out their bonds to foreigners who kept piling in.

True, in case the foreign invasion is misplaced and the locals clever beyond words, this is a great strategy.

But if the fundamentals are far richer than imagined and the invading foreigners have at least shifted their worldviews more than the locals (despite their own limiting home bias first alluded to), then the shape and nature of our present asset boom could be quite, quite different from what preconceived ideas and limited ambition would have prescribed.

The military equivalent is with the German blitzkrieg. When they broke through, their leading generals didn't stop to take leak-and-smoke breaks along the way. That you did on the trot. The only reason to stop was when you ran out of fuel, or the sea blocked your path (or the Great Leader had a brainwave, invariably the wrong one).

Yes, but it is dangerous so far ahead out in front.

True. But that is also where the money is being made, going by what the foreign funds are doing.

Instead of having a limited non-challenging objective and, on achieving it, digging in for prolonged trench warfare (a WW1 mentality), there should be continuous questioning of whether the battlefield is changing and shifting, and to adjust accordingly. Mobile warfare with a difference, information and opportunistically driven.

Patton, Guderian and Rommel would have loved it.

Yet safety in numbers, the peers are all mostly hunkered down, deep in proud cash. Fairly good returns have been rendered and why believe some new snake-oil story?

That's the difference with making ordinary returns and making superior ones in a financial boom of unexpected massive proportions. Let at least the foreigners be pathfinders on this one, don't write them off.

There is something major taking place in the world. Watch the global crowd seeking out the remaining value niches, in some instances WAY beyond our own old benchmarks.

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But these phenomena aren't limited to institutional investment managers.

For business managers suffer exactly the same reality.

Long after the euphoria of the last boom has been cruelly snuffed out, to make way for a deep morose questioning skepticism about pretty well everything (including the daily weather and bowl action), the glacially changing daily operational data is for many the only true guide going forward.

And when the day comes where the recessionary corner is clearly turned, and sales start rising again, even smartly, such good news continues for long to be viewed through remarkably questioning spectacles.

It may not be for real? It may not be sustainable? It could fall off a new cliff? Something will come along to undo it ere long, for it ain't natural to be rising like that? Indeed, this is getting perverse and buying into it the ultimate in folly?

Though admittedly when a credit decision is involved, the NCA now straddles the scene, and especially regarding housing the consumer is expected to come up with cash upfront which many simply don't have and may take years saving. That does put a crimp in things and constitutes a major structural break, at least in that specific sector.

Even so, the real business sector offers interesting examples where business reticence does at present remains a feature, especially the already performing parts that have genuinely left recession behind and are on a rising sales curve.

Here the sales targets have been responsibly set, ahead of the present reality, but still with an expectation mostly shaped in the depth of recession.

And it takes time shaking those many shackles, not least when studying the competition and noticing that they also are taking their time coming out of their foxholes.

What could we possibly know that they don't? Better be safe and stick to recognized norms, that way you can never be told you took undue risk. For after all, you merely did what everyone else did, and how could you get penalized for that?

It is true in exuberant times when many watching everyone else get just a little bit more Dutch courage and go in yet deeper, where sober other-planet-reflection might have suggested differently.

And it applies just as much at the beginning of any upturn where the mindset hunkers down in bunker-like constructions and hibernation remains the comfortable norm, for that is how you got through winter.

Only a growling stomach may then finally push you back to the surface, only to be surprised by a full-blown spring?

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Our policymakers are really no different, studying risks about the future, and certainly taking the negatives fully on board, but otherwise preferring the certainty of the here-and-now data. That way, you at least know what you are dealing with compared to potentially getting completely lost in Never-Never-Land.

As to opportunity foregone it gets buried in the counterfactual to which few people pay much attention for long. For it is the here and now, that offers the next bite at the cherry and is all that really matters.

Or does it? Especially stock markets have a way of differentiating between standard and superior stories, valuing companies (and countries) differently, often reflecting the way they called the future.

But the final word on how to get the mindset in gear should perhaps go to ex-Fed chairman Alan Greenspan. He has reportedly said that it is useless to try to stimulate business animal spirits as long as they are still fearful of another financial calamity.

What's required is an extended period of calm, long enough for managers to regain their confidence and start thinking about new opportunities again. In other words, what is most required now is boredom.

Reference

Jerome Booth, "Emerging Nations: A Beacon of Opportunity" Financial Times 25 October 2010

Peter Coy," A $14 trillion economy stuck in neutral", Bloomberg Businessweek, 24 October 2010

Cees Bruggemans is Chief Economist of First National Bank.