Sent: 25-08-2009 11:52:01
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Slogans versus Analysis
Some of the most popular investment themes of the past few years seem to have lost their lustre. Supercycles, market decoupling and even diversification turned out to be little more than slogans.
Once an investment theme becomes well known by a single name or phrase it has probably become too simplified to be worthwhile. Broadly based investment themes can be important in framing reference points and describing trends. There is a danger, however, in generalizing too wildly and, in doing so, ignoring important analytical detail.
The so-called supercycle was intended to convey the idea of a prolonged expansion in resources sector output accompanied by an unprecedentedly long price cycle. At its centre was China and an insatiable appetite for raw materials.
Over time, an important observation about the role of China turned into a caricature as the supercycle proponents forgot that most of the world was not Chinese and that a downturn in the advanced economies could damage commodity markets.
Also, few analysts considered the importance of global monetary conditions in supporting commodity prices. Declining growth in global liquidity withdrew the speculative fuel and signalled a fall in commodity prices.
Any model linking commodity prices with movements in global liquidity or low U.S. interest rates would have forecast commodity prices starting to rise in the mid 2000s toward historically high levels. This could have been inferred without any reference to the role of China.
Decoupling suggested that individual economies like China could sustain growth rates while others suffered recession. The argument rested on domestic demand becoming more important and export demand less important in their economic makeup.
This was partly based on a flawed reading of statistics. A small net export growth contribution did not mean that international trade was unimportant. It simply meant that the difference between imports and exports was small. Theoretically, economies whose production base is dominated by trade could receive a small net trade benefit.
However, and more importantly, we have also seen how domestic demand is increasingly linked via financial markets. Movements in globally connected financial markets affect wealth and income around the world with increasing speed. Technology and diminishing constraints on capital flows mean that investment decisions are taken more quickly by more people at the same time.
Price signals moving rapidly through financial markets are having a speedy impact on domestic economic conditions. Decoupling advocates concentrated too much on the sources of growth in the real economy. Its proponents forgot how the world was being bound together more tightly than ever by the integration of financial markets.
Diversification was not there when it was most needed in 2008. Multiple lowly correlated assets were intended to save portfolios from the volatility extremes that individual markets can display. Lowly correlated assets were being synthesized if they were not readily at hand.
In this case, the proponents forgot that, ultimately, assets need to be based on some form of wealth and cannot be created at will and indefinitely. Events which indiscriminately cut wealth will likely affect asset values. Diversification will only work if wealth effects are geographically or sectorally limited.
Moreover, with so many financial markets depending on favourable liquidity conditions for their pricing, diversification is less likely to be available. In the extreme, all financial markets will be affected by swings in liquidity induced by the U.S. Federal Reserve and, to a lesser extent, the policymakers in Europe.
No doubt, we have not seen the last of the overly simplistic conclusion which seemingly eliminates the complexity of the investment markets by offering a one-way bet. However, perhaps, through experience, we can be a little more wary about the single word investment strategy such as supercycle, decoupling and diversification.
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