Monday, January 14, 2008

Relative Returns By Asset Class

The above table clearly depicts the shifts in performance of different asset class. It is a very useful table to decipher the macro developments and how capital are being allocated to chase after various asset class.

The spectacular performance by REITs from 2000-2006 was largely due to the property boom in the US. The property boom was largely ignited by the "invention" of REITs itself. The availability of REIT allowed many commercial property owners to unlock cash from their long term hold type asset. The unlocking of cash also helped charge up the rise and rise of private equity and hedge funds (where most of these excess cash went to). If you chart the absolute rate of returns year by year (2000: 31% 2001: 12% 2002: 3.6% 2003: 36% 2004: 33% 2005: 14% 2006: 36%). The sub prime mess and the beginning of the property correction in the US also contributed to the negative 17% returns for 2007. Safe to say that from the above that there may be quite some distance to go for the excesses to be unwound from the US property market still after such a prolonged run. Can expect 2008 to post negative returns as well.

Commodities had a wonderful run with the exception in 2001. The continued weakening of the USD coupled with the new middle class emerging in BRIC countries will ensure a more sustained run for commodities. The bull cycle does not appear to be over by any means.

Emerging markets (including Malaysia) were still reeling from the liquidity contraction and correction from the excesses of the 90s from 2000 to 2002 (2000: -32% 2001: -4.7% 2002: -8%). However, the last 4 years were boom time Charlie days for emerging markets (2003: 51% 2004: 22% 2005: 30% 2006: 29% 2007: 36%). Naturally if a single emerging market were to post those kind of returns, we are looking at a ridiculous compounded growth rate. Though the returns were explosive for emerging markets, there were a lot more rotational plays among those emerging markets. Malaysia only got into the groove in 2005-2007 and was largely ignored by most in 2003-2004. Colombia, China and India were the stars for the last 4 years.

Now going forward we may see that drifting to Vietnam and some of the smaller African markets. What is important to note is that despite the massive rotational plays, most emerging markets still managed to keep most of their gains even when they were not among the top performers year in year out.

Foreign (non-US) developed markets stocks also shared a similar pattern with emerging markets, in that they posted negative returns from 2000-2002 (2000: -14% 2001: -21% 2003: -16%). They posted above average returns from 2003-2007 as they basically obtained great impetus from the enlarged outsourcing into BRIC countries, which helped established companies to save enormous costs: at the same time the rise of BRIC inhabitants as a new consumption middle class provided plenty of opportunities for all concerned. A wonderful win-win situation, a real positive from the globalisation movement. Hence the high correlation between the developed markets and emerging markets. Save to say that that trend is likely to continue into 2008. Owing to higher volatility, the emerging markets as an asset class will usually outperform the developed markets during bullish phases.

US stocks have largely underperformed the foreign developed markets from 2003-2007 (Foreign/US 2003: 38%/31% 2004: 20%/12% 2005: 13%/6% 2006: 26%/15% 2007: 11%/5%). This can be explained by the complete shift in investing paradigm and global economics. One can say that while the US may still be retaining global business leadership, it has had to share out a lot more "equity/economic power" to other developed markets and emerging markets over the last 5 years.
The various bonds asset class' performance over the last 5 years was largely due to the shifts in global currencies realignment. Non-US bonds outperformed US bonds significantly.

Can we use the relative returns table to predict 2008 and beyond? Maybe 2008 with some confidence but beyond that would depend on too many uncertainties to make any calls with assurance. Emerging markets posted strong returns of 29% and 36% for 2006 and 2007 respectively. While the economic structure has changed sufficiently to provide a stronger framework for emerging markets going forward, it is unlikely to reach the same kind of returns in 2008.
It will be a lot tougher for emerging markets as a whole to end the year on a positive note (please refer to the inflation factor, the US weakness and commodities price outlook below for reasons why).

REITs is an easy call. Probably negative return for 2008 as an asset class. Of course foreign REITs may experience better returns owing to better fundamentals. However as an asset class, the sheer size of US REITs would skew the curve.

US stocks will continue to under perform foreign developed markets in 2008 as its returns is now weighted as a significant percentage of foreign markets vibrancy. Owing to the uncertain domestic economy, the US stock markets is likely to stand in the shadows of foreign developed markets in 2008 and even 2009.

The best performing asset class for 2008 is likely to be commodities, looking at the demand and supply factors. The supply side of things cannot be increased solely by ramping up production that easily. The time lag is still in favour of sellers. Take the oil example.
World consumption will rise to 87.8m barrels a day this year, 2.1m more than last year, or about the amount that Nigeria supplies. Demand from China alone will rise 5.7% to 8 million barrels a day as imports expand to support an economy that is likely to grow 10.5% in 2008.

Oil suppliers are straining to increase production. Brazil's Tupi field, the second-largest find of the past 20 years, is more than eight kilometres below the ocean surface and will take at least five years to develop. Mexico's state oil monopoly, Petroleos Mexicanos, suffered a three-year, 40% decline at its Cantarell field, the world's third-largest. Since December 2005, fighting in Nigeria has reduced production 11% to 2.18m barrels a day.

Its the same for agriculture products. According to Bloomberg, agriculture products were among the best performing commodities for the past 13 months where palm oil has gained 56%, soybean 75% and soybean oil 62%.

A fairy tale - Once upon a time, the world was just an island where there were 1m inhabitants with resources to feed and supply 1m people. Suddenly, 300,000 new inhabitants came to the island from nowhere who are willing to work for a lot less and produce at a higher rate. The 1m inhabitants enjoyed cost savings and a better life style. But now, there is this additional 300,000 consumers. Suppliers ramped up production for everything to meet the new demand. Prices rose to rebalance the equation. The council of advisors decided to print more money into the system bringing about simmering inflationary pressures.

The present economic reality is akin to the fairy tale. The commodities upcycle this time may not be all hot air or even just cyclical in nature. Demographics have changed, consumption patterns have changed thanks to globalisation. We are just not sure if this has a fairy tale ending a few years down the yellow brick road.

Inflation - The one big danger which could rein in equity returns win 2008 will be inflation. Food prices are 18% higher in China from a year ago, and Beijing fears that runaway inflation could ignite social unrest. The price of pork, which forms the core of most Chinese diets, was up a staggering 56%. China has become a victim of its own phenomenal success. China’s economy expanded at a blistering 11.5% last year, but was plagued with a 7% inflation rate, largely linked to the country’s voracious appetite for global commodities. Even with a more subdued growth rate in 2008 of around 10%, the inflationary pressures will take a lot longer to work off.

In the U.S, producer prices were 7.7% higher in November from a year ago, the highest in 34-years. Consumer prices rose at an annual rate of 4.2% through the first 11-months of 2007, the most in 17-years, thanks to soaring food and energy prices. The same scene can be replayed in almost all countries, especially in emerging markets. Having said that, that factor will actually fuel the commodities upcycle.

US Factor - The sub prime fallout has started a more widespread correction in real estate, and may crimp consumption in the US. In the UK, a similar pattern, albeit less severe, is evolving. The danger is clear as many emerging markets still rely on the US to export to. A pullback will keep most emerging markets' run up in check in 2008.

The Pendulum - The pendulum has swung, now emerging markets will have to contend with strong local currency, enlarged capacities, inflationary pressures, higher prices, plus a weakening US economy. The US economy have settled for low growth, some inflation, weak USD (to make their assets more attractive): thus shielding themselves somewhat from excessive money supply growth repercussions, now unwinding in our face. Its going to be a difficult 2008.

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