Crunch time stokes climate of fear

From a thematic perspective, 2007 saw an evolution in the merger and acquisition (M&A) cycle and contrasting fortunes between the real and financial sectors of the market. The real versus financial divide was exemplified by positive impetus for emerging markets, infrastructure, commodities and the environment, and negative experiences for investors in some financials and other investments exposed to localised liquidity shortages. Liquidity concerns underpinned a reassessment of risk in credit markets, for example, American subprime mortgage holders or issuers of commercial paper.

Occasional murmurs of an economic slowdown at the start of 2008 grew louder. Recession is ascribed a 30-40% probability on most models. This year has seen periods of denial, accompanied by various iterations of the decoupling debate, for example whether demand from emerging economies can counter the effects of the loss of the American growth engine. What is definite is the repricing of risk and more caution on the part of investors. Volatility in equity and bond markets hit peaks last seen in 2003. Rising short-term volatility has increased the cost of portfolio insurance and encouraged investors to adopt longer-term time horizons.

Changes in M&A have occurred partly as a natural cyclical progression and partly as a consequence of events in the credit markets. Cyclical drivers resulted in more hostile and more international transactions. For instance, $200 billion (£98 billion) was spent buying 300 Dutch companies, including the €71.5 billion (£51 billion) RBS consortium acquisition of ABN Amro. Spanish acquisitions of British companies included BAA (Ferrovial) and Scottish Power (Iberdrola). Credit availability has been a trigger for M&A evolving from debt-financed private equity to cash purchases, increased attempts to renegotiate purchase prices and the abandonment of some transactions. Sovereign wealth funds and emerging market companies have joined the roster of acquirers, buying stakes in financial, technology and resource companies.

The American subprime market started to unravel in February when the market was spooked by rising delinquency rates. By August local woes in American homebuilders and mortgage originators were spreading to the broader secondary markets for mortgageand asset-backed securities, including short-term commercial paper. The next to suffer were banks dependent on the interbank markets for their financing. Companies such as Northern Rock were caught up. The ongoing impact has serious implications for the broader economy as credit becomes harder to come by. For instance, small companies, responsible for much of the growth and job creation in America, are more dependent on bank credit and any curtailment in lending will add to the headwinds faced by the American economy.

The need for infrastructure spending is pressing in both emerging and developed markets. Power cuts, collapsing bridges in America, overwhelmed flood defences in Britain and congested roads, ports and airports underlined the need for substantial infrastructure investment in developed countries. Urbanisation and a growing ability to finance projects in emerging countries were additional factors in the huge backlog in demand for investment in infrastructure.

Climate change was a focus for politicians and the public with added impetus from high prices of fossil fuels and concerns over the security of energy and water supplies. Water maintained its status as a strategic commodity. ‘Clean tech’, relating to areas such as sustainable water recovery, distribution and disposal, as well as some types of alternative energy became one of the new buzzwords, with sustainable market growth estimated in excess of 12% a year. Enthusiasts hailed clean tech as akin to biotech rather than being the new dotcom. Corporate bond investors saw opportunities in water and energy utilities and project finance. As environmental investing matures as a theme, we are seeing a little more discrimination and disillusionment with alternatives, such as oil sands and heavily incentivised corn-based bio fuels, and growing scepticism about overly ambitious political targets.

Commodity returns for American investors have been three times higher than those from equities and double the returns on US Treasury bills in 2007. The drivers have differed for various market sections although the declining dollar has been common to all. Prices of soft commodities have risen as a consequence of growing affluence and changing tastes in emerging economies and the diversion of crops for biofuels, as well as traditional harvest and weather-related factors. Industrial metals have seen robust demand from infrastructure projects and continued growth in emerging economies. Precious metals, particularly gold, have fulfilled various roles from safe haven from volatile markets to a store of value in the face of the decline in the dollar. Energy has been in demand and any supply disruptions or political disruptions have been seized on, pushing the price close to the $100 per barrel mark.

“Urbanisation and a growing ability to finance projects in emerging countries added to the huge backlog in demand for investment in infrastructure”


Global thematic strategist at Standard Life Investmentsnigel Thomas

Fund Manager