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Tuesday, January 22, 2008

Relative returns by asset class - Outlook of REITs market in 2008

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.

(Refer to table) The 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 is being allocated to chase after various asset classes.

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). This is the absolute rate of returns year by year for REITs – 2000-31%; 2001-12%; 2002-3.6%; 2003-36%; 2004-33%; 2005-14%; 2006-36% and 2007-17%. Needless to say and it continues to unravel even now, the sub prime mess and the beginning of the property correction in the US contributed to the negative 17% returns for 2007.

Safe to say that there may be quite some distance to go for the excesses to be unwound from the US property market after such a prolonged run. With that, 2008 is expected to post negative returns as well.

Run on commodities

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 (Brazil, Russia, India and China) 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 four 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 kinds of returns, we will be looking at a ridiculous compounded growth rate. Though the returns were explosive for emerging markets, there were a lot more rotational plays among them.

Malaysia only got into the groove in 2005-2007 after being largely ignored in 2003-2004. Colombia, China and India were the stars for the last 4 years.

Going forward, we may see investors drifting to Vietnam and some smaller African markets. What is important to note is that despite the massive rotational plays, most emerging markets 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 2000-2003 (2000: -14%; 2001: -21%; 2003: -16%). They posted above average returns from 2004-2007 as they basically obtained great impetus from the enlarged outsourcing into BRIC countries, which helped establish 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.

It created a wonderful win-win situation and a real positive from the globalisation perspective. It also brought about a high correlation between developed and emerging markets. Save to say, the trend is likely to continue into 2008. Owing to higher volatility, the emerging markets as an asset class usually outperform the developed markets during bullish phases.

Investing paradigm shift

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 with some confidence for 2008, but beyond that would be difficult as there are 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 reap similar returns in 2008. It will be a lot tougher for emerging markets as a whole to end the year on a positive note, not least due to the inflation factor, the weakness in US and the commodities price outlook.

Whither 2008?

REITs is an easy call. As an asset class, it would probably record negative returns in 2008. Of course foreign REITs may experience better returns owing to better fundamentals. However, the sheer size of US REITs is likely to skew the curve.

US stocks will continue to under perform foreign developed markets in 2008 as its returns are 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, but that may not be a bad thing.

The best performing asset class for 2008, based on the demand and supply factor, is likely to be commodities (it is not easy to simply increase supply by ramping up production).

The time lag is still in favour of sellers. For example, oil. World consumption will rise to 87.8 million barrels a day this year, 2.1 million 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 2.18 million barrels a day.

It's 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%.

Of reality and fairy tale

Once upon a time, the world was an island with a million inhabitants and resources to feed and supply a million people. Suddenly, 300,000 new inhabitants came to the island from nowhere, who were willing to work for a lot less and produce at a higher rate. The 1 million inhabitants enjoyed cost savings and a better life style. Suppliers ramped up production for everything to meet the new demand that arose from the additional 300,000 consumers. 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 and consumption patterns have changed, owing to globalisation. But how sure are we that this shift will result in a fairy tale outcome a few years down the yellow brick road?

The scourge of inflation

The one big danger which could rein in equity returns in 2008 is 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 US, 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 highest in 17 years due to soaring food and energy prices. The same scene can be replayed in almost all countries, especially in emerging markets.

Having said that, such factors serve to fuel the commodities upcycle.

The sub prime fallout has started a more widespread correction in real estate, and may crimp consumption in the US. In Britain, a similar pattern, albeit less severe, is being played out. The danger is clear as many emerging markets still rely on the US for their exports. 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, demanding valuations 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 right before our very eyes.

The US still have to contend with sliding house prices, a decline in consumer spending, rising credit costs, and a significant slowdown; lowering interest rates may not provide that big a help.

In other words, it’s going to be a difficult 2008.

  • S Dali is a pseudonym. He is an ex- analyst/fund manager and active blogger. ( who says he is too young, too old, too sarcastic, too dark, too funny, too charismatic, too poor, too Cantonese, too Malaysian, too frank, ... too bad.

    For perspective, this piece was written on Sunday prior to the correction across most major markets over the week

    Investment Scents post by The Star - (by S.Dali)

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