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Cloud Call Center Community Featured Article

[August 20, 2006]

Interest rates and volcanic eruptions

(Gulf News Via Thomson Dialog NewsEdge) The summer holiday feeling coincides with the bridge between H1 and H2 for every year, a time when the perennial seasonal question for fund managers emerges: "What is in store for the second half of the year?"

Throwing the question at Howard Smith, the lead fund manager within the Symphony Range of funds and QIM Asset Management, produced a bit more than expected for 2006: a hot tip shrouded in deep philosophy. You can't have your top tip without an understanding of the philosophy so here goes: 'Remember the film Krakatoa, East of Java?' asks Smith.

Eventually, and with apologies to those that have studied geology for years, we get to the point that much of Indonesia has been created by violant eruptions and clashes of the earth's tectonic plates.

The violence of eruptions is but the spectacular conclusion to daily, on-going, movement of the world's tectonic plates. Dubai Marina seems only moveable by man-driven cranes, but underneath the earth's core is more fluid and is moving all the time.

"This is the world economy," says Smith. "There are daily movements that are slowly, yet clearly, building a new world economy, the equivalent of Indonesian geography. We are experiencing continual movement with occasional eruptions as we move from one pattern to another."

If you push me for a film title to Smith's economic philosophy it might be Eruptions East of New York. Two points to help explain what might be the world's first economic film classic: the first is the habit of looking at the US as the leader of the old world pattern.

The fact is that the US remains the world's largest economy, so in terms of what is happening TODAY, what happens in the US matters and influences the entire world economy.

"The US remains the world's buyer," says Smith, "but in the future it might become the world's biggest borrower," implying the future will change. As the world's biggest buyer what happens in the US in terms of major markets and interest rates therefore is of interest to the world.

It remains a risk for global investors to ignore US equity, bond and alternative markets simply because the world's biggest buyer, in a world driven by supply and demand, still strongly influences prices.

East of New York, though, the daily movements are taking place and eruptions on the way are becoming increasingly likely. For Smith the econ-omic plates to watch include: Europe, China and India, and "a Southeast Asia driven by the Japanese dynamo". "It might not all be spectacular eruptions," says Smith, "but every time a factory is set up in China, a job is lost in the US. On a daily basis, sedimentary economic material is being deposited in China with an erosionary quality in the USA," says Smith.

China is perhaps the most impressive eruption of recent years. Over the last five to ten years China was outside the world's top eight economies. They are now moving into fourth with a growth rate the others, perhaps with the exception of India, can't match.

Smith laughs at the joke doing the rounds that the G8 meetings of the world's richest countries have dinner settings for ten. The rich simply can't afford to inore the wannabe and will-be rich in China and India. If governing a country is all about leaving a better future for your children, it is logically imperative for your children to have good relationships with the rich!

For Smith, the Japanese and European economic plates are also depositing growth. Fidelity recently pointed out that fund inflows into European domiciled funds are greater than into US domiciled funds. Smith adds that Europe seems to be becoming more succesful at IPO and Private Equity activity, with a loss to US interests, adding that "although the US stock market is doing OK, the Nasdaq has experienced a number of losing months and is experiencing competition from the likes of the AIM market in the UK." Clearly, things simply ain't what they used to be.

The changing patterns of economic tectonic plates isnt simply a geographic thing. Patterns of investing habits are also changing. "Traditionaly," says Smith, "equity markets were the number one driver of investor returns. Today, investors are increasingly being led towards increased diversification and absolute returns."

Smith points to his early years in the business when "in the 1970's institutions such as pension houses, life insurance companies and so on, owned the vast majority of shares in the major markets. They also owned the vast majority of new money coming in. In the UK the figure must have been as high as 80 per cent."

This was a period when the institutions expected on-going inflation, and on-going equity market growth, and were more prepared to hold assets long with minium short term changes.

"The new paradigm towards absolute returns was originally driven by hedge fund managers. Today, the alternative investment managers now drive over 55 per cent of trades in the UK market," says Smith. In short, the owners of shares and the number of trades have changed from the old-fashioned institutions to the world of alternative investment. Their taste has also changed from holding long and tracking indices to being in as many of the right markets as possible at the right time.

For the patient, this takes us onto the hot tip. If being in the right place at the right time is important, and if we are looking for the next asset eruption than Smith looks to the bond market.

"Inflation in the US is at its highest point in five years. Bernanke has indicated that he is willing to increase interest rates by only a few bleeps on the meter. This all indicates that we are near the top end of the interest rate cycle. The point being that investors will start seeing this point as the point to start buying bonds," says Smith.

Fact file: So what's Smith's top tip?

The top tip: buy bonds. To Smith: "Equities are still relatively cheap, but what can you expect for the rest of the year? Perhaps 7 per cent or so. Bonds might also offer 7 per cent but with much less risk."

The bond tip reflects the philosophy. The current state of the world means that investors, like it or not, need to keep one eye focused on what the world buyer, the US, does. Today, it seems, US and most global interest rates are moving towards the top of their cycle.

Conclusion: short term tip: buy bonds. However, global economic tectonic plates are such that the bond tip is merely a little eruption within a world where the big eruptions are taking place to the east of the US In Europe to an extent, in Southeast Asia for sure, and with a certainty in China and India that neither we nor our children should ignore.

- The writer is managing director of Mondial (Dubai) LLC.

Copyright 2006 Al Nisr Publishing LLC. Source: Financial Times Information Limited.

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