The bear market rally fizzled out again on Friday. Those optimistic on the earning season early in the week were disappointed later in the week. Yours truly maintain his bearishness – we need more from Uncle Ben. If Obama wins next month, Uncle Ben will keep his job and thus a low could form as early as Feb 2013. An unlikely Romney win would postpone the low given his aversion to printing money.
It is instructive to look at the recent outperformance of the financial industry:
“…Eleven of the these fourteen [financial] sub-industries are reporting double-digit earnings growth, led by Regional Banks (50%), Real Estate Services (39%), Insurance Brokers (39%), Specialized REITs (35%), Residential REITs (29%), Property & Casualty Insurance
(25%) and Diversified Banks (20%)…”
As regional banks are leading the growth, chances are, we are seeing the:
1. decline of innovative finance driven by regulators overreaction – Basel3 & Dodd-Frank.
2. resurgence of boring finance as bank loans to Main Street remain expensive despite the low interest rate environment.
The rise of boring finance at the expense of innovative finance is concerning as it is a financial tax on Main Street.
We are likely to see the rerun of capital flight of the 1930s driven by the same forces of sovereign debt crises. Since the crisis is in public assets, the likelihood is that capital will flight into private assets. However, since capital is fickle, the swings would be spectacular. Those who leverage up to the hilt should remember that the journey matters as much as the destination, if not more. For instance, we began this year saying that the Chinese Yuan will remain a one way appreciation bet this year. The core view was right, but the journey had been anything but smooth.
Since housing is the most heavily leveraged private asset, recipient countries should tighten regulation on the housing market among the locals. Singapore did the right thing by regulating the tenor and the loan to value ratio. To be sure, the price of money does not matter as much. If people think prices will rise by 10% a year, they will still borrow at 8%. It is the volatility that will be the most damaging.
One should also reallocate capital away from weak local hands. In aging societies, low interest rates robs the elderly of interest earnings, thus forcing them to invest their life savings into rental properties. Since the motivation is generally to keep up with inflation, governments should issue honest inflation link bonds for retail investors. That would reallocate capital intended for the property market into other projects. It is important to sell it directly to locals. If a foreign entity bought all the inflation bonds, foreign money entering the country will stoke currency inflation, and likely push even more locals to buy rental homes as an inflation hedge.
Despite all the mistakes in Europe, the Italians did something right recently. They sold 18b worth of inflation bonds via an eBay-like system directly to locals. That helped the Italians to reallocate local capital to solving their sovereign debt crisis. The capital flight destinations in Asia should learn from the Italians on inflation linked bonds for locals.
Good luck in the markets.