The World Rediscovers Risk

June 2006 Dr. Hans Black

Just prior to the arrival of spring this year, the changes were evident; only two years since the tragic bombing in Madrid, and just nine months since the London bombings, geopolitical anxieties had more or less subsided. Financial worries over such credit issues as Delphi and GM were alleviated by the use of ever-more-popular credit derivatives that serve to insulate participants from risk. The world was happy with the new head of the Federal Reserve, Ben Bernanke, who, it was thought, would be a relative dove compared to his predecessor. Commodities were bid up, as oil had been for quite a few months, but now the desire by investors and hedge funds to enter base metal trading, as well as to bid up equities on a global scale, took off. Then, just before mid-May, credit spreads widened a little bit and the U.S. Federal Reserve Board let it be known it might be more inclined to tighten than many had anticipated. Stocks sold off and the result was one of the worst Mays on record.

Led by severe declines in emerging markets, particularly Indonesia, India and Russia, shares dropped almost around the globe and by May 19 many of the gains for the year had been wiped out. Concerns over higher inflation rates — and therefore higher interest rates — bubbled to the surface along with a continuing uneasiness over the situation with Iran. Perceptions changed seemingly overnight, but the exit doors proved to be quite small and many markets to be not nearly as liquid as some had hoped. Such was the situation that the World Health Organization had only to mention the phrase “bird flu” to complete the sense of pervasive gloom.

Although much has been written about the U.S. consumer in the past year, we feel the ultimate surprise will be that he will have to slow down his propensity to spend, for demographic as well as for secular reasons, thereby relieving the load on the U.S. trade gap. The first tranche of baby boomers will turn 60 this year, an event that coincides with the need to reliquify balance sheets that have been hurt by a stock market that has not gone anywhere for seven years and now by housing values that appear to be declining. On the other side of this equation, it is clear that even the slightest weakening of domestic demand in the United States will lead to a great deal of pain in Asia. China, which is already admitting excesses in over-production and over-speculation, will probably be the first to feel the adverse effects, followed of course by Japan, where things have been slowing again over the past six months. In such an environment we believe many equity markets will continue to be under pressure. One surprising outcome, however, may be a stronger dollar.

Another noteworthy news item is the sudden rise of US political concerns over immigration, which will become an important factor in the upcoming congressional mid-term elections. But there is a deeper change going on. Americans, who can generally be described as tolerant, are nevertheless showing strains from the combined effects of higher interest rates, higher oil prices and, of course, much less discretionary spending capability. Such frustrations may find a target in immigration policy, or in any other combination of factors, but the bottom line appears to be a more protectionist-oriented consumer. This, too, might also signal the necessity for the consumer to reliquify his balance sheet, which may in turn lead to a shrinking trade deficit. It is also a signal to de-emphasize vast sectors of the market such as housing, consumer discretionary and a host of credit-sensitive companies as well. We have sought value in health care and biotech, as well as in a host of such special situations as precious metals and energy companies (although in the latter two cases this is hardly the time to go back into these groups). As we have pointed out for a number of months, we believe the second half of 2006 and indeed the early part of 2007 will become much more challenging for many investors. Any month in which the previous half-year’s gains have disappeared is clearly signaling danger. By paying more attention to risk and less to instantaneous gratification, we will develop the seeds for far better and more solid growth later on.