It is entirely likely that the capital markets are and have been since 2009 in renewed form of substantive change which we believe will culminate in greater focus on quality of delivery. Nonetheless, much continues to be made over large day to day point swings in the markets seemingly on rapid fire attributions to daily economic releases, not least from the United States and China but also on global issues of seamless recovery versus double dip presumably into recession. Irrespective of the economic outlook, we see it as likely that the functioning of capital markets now is at potentially the third phase of major change.
The first phase of change took place close to four decades ago in the form of the unveiling of negotiated commissions which at first was considered innocuous but which over time led to radical renewal in both the functioning of investment banks and in the management of money on behalf of clients. In our view, the second phase of change took place close to a decade ago when the explosion of computing technology radically compressed both the time frame and volume of activity resulting in an explosion of participants including the like of hedge funds initially and more lately, the like of high frequency trading, all well beyond traditional monikers such as growth versus value or domestic versus international. Parallel to disagreement over the economic outlook and arguably visible in funds flow and valuation change that has continued during credit crisis, the present third wave of change may be equally radical in the form of the investing client requiring the Wall Street pyramid to invert from the last two phases of viewing the single transaction as the ring fenced be-all and towards viewing the end-all as being the accumulation of gains.
At its essence such change would be radical not for investment banks re-considering their business model structured in the past towards securitization and proprietary trading as appears being required under global financial reform but also for investment management in evolving beyond stretching for the lowest possible transaction cost and towards creating value. In the fixed income markets much has been made and continues to be made about transparency in European financial integration ranging from commercial bank disclosure to European Central Bank supervision to the end point of sovereign debt guarantees, direct or implicit. As we see it, the reality is akin to risk spread dispersion within a single currency bond market, namely that higher risk and lower quality issues are likely to have higher and more volatile rate premiums over the stronger and more liquid. Looked at from this perspective, one major issue in fixed income in 2010 has been that a long entrenched transaction bias inherent until mid year set aside too low premiums for many European sovereign issues, compared to those required from a quality of fiscal structure view point. These discrepancies appear in the process of workout but also need to be considered for the larger jurisdictions like the United States , Japan , Germany and Britain.
In equities, much has been made about valuations being low based on consensus earnings but almost by definition at turning points of which precipitous decline after 2006 or sharp recovery as in 2009 are merely the most extreme, consensus is slow to change. Much like that in sovereign fixed income, the last cycle in equities had in its transaction tilt, a compression of multiples built upon anticipation of a stable cycle – favorable for low quality but which is now in the process of differentiation in favor of quality. Last but not least, much as the consumer appears now striving to be frugal but not stretching for the lowest possible price. We reiterate that corporate spending is likely to be similarly return driven as is already the case for top notch companies. Infrastructure programs introduced by governments are likely to come under similar closer scrutiny for value.
As the markets draw closer to the last quarter of 2010, it is becoming increasingly clear that greater uncertainty about political deliverance is in store. It can be seen in the protracted negotiations after general elections in Australia and Britain as well as in greater friction in the German grand coalition and the U.S. mid term elections incorporate head winds, not the hoped for tail winds from concerted action in 2008/9. In Asia , inter party rivalry in the ruling Democratic Party and uncertain consistency in the Liberal Democrats make fragile restructuring in Japan . Within China and likely in emerging Asia at large, notwithstanding strong growth and confidence, the political issues appear shifting to greater demands for a better quality of life by the poorer and generally more rural segments. It seems to us that for risk, markets will also have to consider the quality of political delivery much more so than was the case in the last decade.