Citi is forecasting that 2009 will be a year of two halves. In the near-term, investment returns are likely to be driven by ongoing trends of economic contraction, policy easing and de-leveraging, leaving equity and credit products volatile. But, at some point in the year, the extreme valuations seen currently in equity and credit markets should provide attractive opportunities, as downside risks to economic growth dissipate and de-leveraging pressures ease. FinanceAsia asks Norman Villamin, head of investment analysis and advice in Asia-Pacific for Citi's consumer banking and global wealth management businesses, how to best invest given that view.
You've expressed the view that distressed asset investors may serve as a catalyst to performance of other risky asset classes. Can you briefly explain why you take this view and how you see this unfolding?
The historical valuation extremes that various asset classes are trading at can be attributed, to a large degree, to the unwillingness or inability of global financial institutions to provide credit or the desire by investors in various asset classes to deleverage (due to the higher cost and more limited availability of credit). To a large extent, we believe this is due to the uncertainty regarding the asset quality on global financial balance sheets.
The beginning of the distressed asset cycle, we believe is key to reversing this situation. Like in the 1997-98 Asian economic crisis, distressed asset investors played the important role (alongside governments and the IMF) of taking these assets of uncertain value off of bank balance sheets. In combination with the addition of new capital to bank balance sheets, banks were then able to refocus on extending loans to creditworthy borrowers. In addition, the beginning of the distressed asset cycle also allow the new owners of the asset to renegotiate terms to allow some borrows who were previously insolvent to, once again, become current on their loans.
As this occurs, the tightness of credit in the global financial system should begin to ease allowing the historically extreme valuations seen today to normalise back towards historical means.
You've also said that value investing provides an opportunity for long-term, equity and credit investors as the bottoming process matures in 2009. That makes sense, but where might investors find that value?
In the credit space, investors can find attractive value in the investment grade space. While spreads across the credit spectrum are near or at historical highs, in the investment grade credit space in Europe and the US, we find that spreads are pricing in default rates which exceed levels seen during the Great Depression! Thus, while a return to depression-type levels in the global economy is not our base case, should it occur, investment grade credit is one of the few asset classes that is already pricing this prospect.
In the equity universe, we are beginning to see bottom up value globally similar to the bottom-up value investors were able to find during the troughs of the 1997-98 Asian crisis. During that period, investors were able to find industry leading companies with unlevered balance sheets trading at market capitalisations which began to approach levels equal to net cash on their balance sheet. Essentially, investors were able to find companies where they could pay to buy cash, dollar-for-dollar, and get the operations at a substantial discount to long-term value. While we haven't found the same number of opportunities around the world in recent months as seen in Asia in 1997-98, with the renewed market weakness in recent weeks, we are finding an increasing number of names which meet these criteria.
You also talk about infrastructure investing. What countries do you think will be spending first on infrastructure? And how can regular investors access this potential growth market?
When thinking about infrastructure, investors should focus on both need and funding availability. In this framework, while emerging markets broadly have infrastructure needs, the global credit crisis is making the funding issue more pressing. In contrast, in developed markets, it is more important to focus on need given the low government bond yields and an apparent willingness by investors to fund deficits, allowing governments to push fiscal stimulus in these economies.
As a result, among emerging economies, countries with strong fiscal/reserve positions like China are well positioned to maintain and even accelerate momentum in infrastructure investment.
Among developed economies, the US appears increasingly attractive from an infrastructure perspective. With traditional government funded infrastructure in the US (roads, bridges, etc.) having useful lives of 30-40 years and with government infrastructure investment having peaked in the early-1970s, the long-cycle replacement of US infrastructure is likely beginning, in our view.
In addition, with the fiscal pressure on US state and national governments, what had historically been public sector funded and built projects have the potential to mimic the public-private sector partnerships historically used in the emerging world. The privatisation of an Indiana toll road for 75 years in 2006 highlights the kind of opportunity available.
Given our view that the opportunity in infrastructure is a prospective long-cycle upturn, we encourage investors to identify investment vehicles whose timeframes match the long-cycle nature of the opportunity. In this case, we believe private equity opportunities provide an attractive way to match the duration of the opportunity with the duration of the investment.
What's your view on high-yield bonds?
While spreads are certainly historically wide in high-yield bonds, at current levels of spread, high-yield bonds are pricing in a "normal" cyclical deterioration in default rates going forward. In contrast, in the investment grade space, investors will find that spreads are pricing in a deterioration in default rates that exceeds levels seen during the Great Depression. As a result, we prefer the investment grade space to high yield at the point.
And government bonds?
At current yields, government bonds do not represent good value in our view. While clearly concerns about deflation and recession may persist for a few more quarters, at current levels of government bond yields investors are not being compensated for the prospect of a return of inflation, especially given the extent of monetary and prospective fiscal stimulus being injected by governments globally. For risk-averse investors who prefer the safety of government bonds, we see better value in inflation protected government securities such as US TIPS.