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Flight to quality intensifies

By Neville Bennett

Friday 11th April 2003

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The recent past, from September 11 to the fall of Baghdad, has more than likely caused enduring changes in global investment psychology.

The bull run from 1990 to 2000 generated a psychology of maximising returns in a fairly riskless environment. However, the pursuit of above-normal rates of return seems no longer to be the pressing issue. The preservation of capital will continue to dominate investment decisions.

The investor is likely to be approached by brokers who insist they have worked out a way to profit from the war.

Some scepticism is in order, for these may well be the same people who three years ago assured their clients that the future lay in the technology and telecommunications sector. The timid who followed that advice lost about 40% of their investment, the bold lost 80%.

There are still many unknowns, such as how Iraq will be administered, whether the UN will be involved and when oil will be available.

These are not minor questions and no one knows the human, financial, political or diplomatic costs. We do not know how the war will affect American confidence, which has been at a 10-year low. However, confidence is central to spending and economic growth.

The bold might already notice a note of caution in the equity market. At the time of writing, it appears Wall Street's euphoria was short-lived. The Dow Jones closed at 8300 on Tuesday. It has made no real headway in a month, despite the brilliant military campaign and the removal of many uncertainties.

It seems economists' warnings that gains could be short-lived has had an effect and investors feel that problems in the US economy will come back into focus, once Iraq stops dominating headlines.

Since the September 11 terrorist attack, investors seem to have upgraded the flight to quality or "hard assets" classes of investments. The search has been for stores of value.

For example, for many years American investors were unconcerned about dividends. But recently stocks that did not provide income have been under scrutiny and many stocks have changed their policy to maintain the market's confidence. Savvy US investor Warren Buffett has been vindicated in buying value stocks.

Moreover, if recent history is not enough to confirm that the world is a dangerous place, investors might be mindful that tensions between the US and the EU, and between the US and the Arabs, will almost certainly confirm the flight to quality. It must also be remembered that there are other unresolved issues in Asia that could disturb the peace.

The tension between Pakistan and India is high; the Palestine issue is no better. North Korea is a terrifying problem; it already has two nuclear weapons and might add six more this year.

The gold price has taken a hammering but some is still worthwhile in a balanced portfolio as it is a store of value and it has surged in price despite central banks unloading vast quantities on the market.

If it is time to get back to basics in investment, then commodities seem of interest. It is easier to determine that a bushel of corn is better intrinsic value than a tech stock.

A dramatic increase in production and security costs is necessary to deal with the new era. Most commentators have scoffed at the idea of inflation but I have argued that it is a possible scenario in the near-term equation (NBR, Mar 28). When inflation combines with investor interest in hard assets, there could be unprecedented activity in commodity markets.

Some inflation is apparent in the US producers price index, which is up 3.5% on a year ago. The war spending by the US is covered by a special budget of $US75 billion but this may be only a downpayment. Some experts believe a $US100 billion bill is a minimum but the maximum has rarely been calculated.

Yale Professor William Nordhaus' worst-case is $US1.2 trillion. His research is broad. It is supported by a Council of Foreign Relations Study that estimates the US will station 75,000 troops in Iraq for several years and cost $US20 billion a year.

The US Budget deficit is already estimated to reach $US300 billion due to war costs, tax cuts and lower tax receipts. Increased security and insurance costs are also inflationary, as are record low interest rates in effect.

The end of Saddam has not removed all uncertainty. On the contrary, it has raised some new issues on which snap decisions could well be avoided. The political situation is murky. One aspect that raises concern is the manner in which the Bush administration seems bent on rewarding its friends and dissing its enemies.

There has been much evidence that Mr Bush is directing contracts to firms that played a positive role in his election and has ruled out businesses from France, Germany, Russia and Syria in playing a role in reconstruction. This is extremely divisive and may be expected to invite repercussions and promote instability.

The markets will continue to be unstable. For example, the war has put the spotlight on the US dollar. It used to be a store of value. Recently it has depreciated, losing 23% against the euro in two years. The dollar may remain weak because of record low interest rates, record trade and budget deficits, a bearish stockmarket and falling confidence.

A depreciating dollar upsets many calculations on which wealth is founded. Not many people realise that foreigners hold $US7 trillion of US assets and they may not enjoy getting low yields in a depreciating currency. They have already started moving out of US assets, which could be a harbinger for further depreciation. A fall in the value of the dollar may also be a great stimulant for commodity prices.

The lesson to be drawn from the war is that is has not resolved uncertainty. Some issues have been settled but perhaps more have been raised. The investor will have to be alert and cautious.

Beating the market is hard in these unpredictable times. The market will respond and adapt to all changes and uncertainties. In addition, in the end the market is smarter than any broker.

Bond Offer: Infratil Ltd, 7.2 year & 10.2 year unsecured unsubordinated bond


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