The Four 'C's: Currencies, Commodities, China and Confidence

Adrian Clayton of Alphen Asset Management writes that regular readers will know that Alphen takes a long-term investment view; the investment team were bullish last year believing that markets were cheap but they never imagined that the rebound would be as steep and as quick as it has been.

 More recently we have become rather cautious after these substantial market gains - we simply don't believe that equity returns from current heady levels will be impressive.  Today I will discuss four global risks that have added to our concerns.   We have for ease of memory, named these the four 'C's.

The first 'C' is for currencies.

In the past year emerging market currencies have again been the flyers on the world's currency stage.  In fact, of the 16 top performing currencies of 2010, five were emerging of nature and the top two were the Brazilian Real which gained 33% and the South African Rand, which rose 28% against the dollar. 

Of even more interest is that the top six performing currencies against the dollar were all from commodity orientated countries.  Our concerns regarding the strength in these currencies relates to the fall-off in exports that is occurring in many industries operating in these economies.  Most of these nations are trying to build up more advanced high-tech industries and do not want to be reliant on primary products for exports.  However, the extreme appreciation across their currencies has resulted in a serious reduction in important export products.  An example is vehicles produced in Brazil where exports have collapsed in excess of 40%.

Furthermore, much of the currency strength seen across these markets has occurred due to 'hot' portfolio inflows from investors who tend not to take a long-term view on matters.  Our first warning is thus one of being very careful chasing this trend of emerging market currency strength.  On this note, we view the rand as approximately 20% overvalued relative to the US$.

Our second concern is the strength that has occurred in commodity markets this past year.  Again, we will not go into much detail, but suffice to say that commodity prices have appreciated precipitously since the market reached lows in early 2009.  Copper as an example, has again reached prices that are almost as high as the heady levels reached in 2008 when we were desperately worried about the metal's price levels. 

Copper at its highs, exceeded $8000 dollars a ton, then fell in the market correction to $2770 a ton and has again ballooned to almost $8000 before settling at $7100 at present.  Our real concern is that commodity markets are increasingly or disproportionately relying on China as the end user.  Many resources are not enjoying balanced global demand or support and instead China is the primary engine of interest.  Based on this skewed demand perspective, we are concerned that many commodity prices might si mply be too elevated.

Thirdly, we are worried about China.  The greatest problem for us with respect to China is that it is an economy that is really difficult to understand and it is in the midst of an economic experiment which is untested. China's economy is best described as centralized or controlled capitalism. 

But whilst the experimentation taking place is untested and its success is still to be determined, what is an immediate worry is the debt creation occurring in China.  The Chinese Government instructed commercial banks to hand out debt liberally to buoy the economy last year.  This meant massive money creation that has the potential to create dangerous asset bubbles.  Already it is estimated that as much as 33% of this debt has filtered into risky assets like property and equities and created artificially high markets.  We also believe that this 'excess liquidity' has been responsible for a great deal of the strength which has taken place in commodity markets.  So our view is that China is an enigma in many respects and global economic risks have risen as the country now manages itself through this phase of increased debt within its financial system.

Lastly, we are worried about market confidence.  Ironically, we are not concerned about a lack of confidence but in fact precisely the opposite, over-confidence.  We look at market confidence indicators and it concerns us deeply that market participants are almost as confident now as they were before the market crisis in 2008 and early 2009.  At that point market confidence was at extremely high levels.  Then during the market correction we felt that investors were way too pessimistic about the world and the doomsayers were in our view, wrong. 

Fortunately, this has proven to be the correct interpretation of events.  Right now though, we are puzzled by the degree of optimism in the system considering the world really did change for the worse in 2008.  Markets are presently behaving as if the global economy is bullet proof whereas it actually was wounded rather severely in 2008.  It remains an injured patient but is being treated by investors as if it is a hulk-like, testosterone infused teen.  This is not rational and any unpleasant economic or corporate surprises are very likely to seriously upset markets whilst they are in such a positive mind space.

So in conclusion, we are warning about certain emerging currencies (including the rand) that we view as too strong, commodity markets that have entered the stratosphere, China which is undertaking an untested economic experiment and market confidence which is too zealous.  These are real risks to many markets, but with sound asset allocation and competent stock picking, many of these hazards can be reduced and we remain confident that patient clients will enjoy sound returns in the years ahead.

The Alphen Angle is an electronic newsletter of Alphen Asset Management. To read more about Alphen please go to AlphenAM.co.za.