Adults are only kids grown up.
- Walt Disney
Disney's enduring attraction was updated and revamped last year, but its theme resonates even more today than when the attraction opened at the 1966 World Fair and subsequently moved to the Disneyland Park in Anaheim. As Walt Disney noted, we truly are kids at heart — we have short attention spans, fleeting memories and want to believe in happy endings.
What other explanation is there for the fact that a year after the terror attacks in Mumbai, there is seemingly no additional risk premium attached to Indian assets? Why were the markets caught unprepared by the recent announcement that Dubai World was looking to restructure its debt and postpone interest payments? Couldn't these risks be better calibrated (in the case of India) and anticipated (in the case of Dubai)?
A Year After the Attacks in Mumbai
I spoke to people who were in Mumbai at the time the attacks took place and I knew one of the victims as well. I was told afterwards by residents that the trauma would take a long time to heal, while investors said the incident would forever change the way India was perceived. It would go back to being viewed as merely another risky emerging market, as opposed to being one of the elite BRIC nations and a global and regional force, both economically and politically. In other words, optimism about India's longer-term prospects had suffered a serious, perhaps permanent, setback. Happily, they were wrong and optimism returned — had it not, it would have meant the terrorists had won.
How about the risk premium associated with India, however? There have been concerns voiced in recent years about not just terrorism risk, but also India's budget and trade deficits, inflation, reliance on imported oil and elevated equity valuations. With the current focus on returns and yield, most of those concerns don't appear all that important anymore. If this sounds like the pre-Lehman bubble world we have supposedly learned lessons from, it is not far removed. That is not to say I don't believe India has a compelling future and growth story to tell — it does. What I question is the way markets perceive and price risk when times are good, rates are low and central banks have ensured the world is awash with liquidity. In my opinion, India is just one example of mispriced risk and there are several others.
Dubai: An Isolated Case, or a Harbinger of More Defaults?
I spent several months in Dubai over 20 years ago. A lot has changed visually in the emirate since then, but the core reality remains unchanged. Abu Dhabi was the emirate with most of the oil, was fiscally conservative and was the seat of political power. Dubai, on the other hand, with no oil reserves to speak of, had ambitions of being both the Las Vegas and Singapore of the Middle East. To further those ambitions, they embarked on a massive building and public relations spree and made themselves into, among other things, a golfing mecca by courting the global PGA tours and by transforming arid desert into lush fairways through the magic of desalination plants. They hoped that trade, tourism and real estate would boom and justify this ambitious — some might even say excessive — expansion. Lenders in the pre-Lehman era were happy to oblige as the distinction between sovereign risk and implicit (read uncommitted) government guarantees became blurred.
After Dubai World's announcement, I have seen articles claiming that lenders will no longer assume implicit governmental guarantees are equivalent to sovereign debt. Really? You might wonder why investors should necessarily reach that conclusion in most cases, when you consider the bailouts undertaken by governments of non-sovereign borrowers over the past couple of years. I suspect that unless this issue gets resolved quickly, it may result in the Bank of England and other central banks adding liquidity to the system to get past this hiccup. Get past it we will, as Dubai's obligations are not nearly large enough to derail the system, but perhaps the result will be the formation of another bubble down the road as the price for being bailed out of this one. Once again, liquidity will win the day — and once again, a lesson might not be learned.
Market Behavior: More of the Same
Currency markets reacted predictably — the dollar rallied as did the yen, which is typical in times of risk aversion. Flows into treasuries help explain the dollar rally, but the yen's gains versus the dollar are somewhat harder to explain or justify. It is no longer the "funding" currency in carry trades (the dollar is), nor is Japan a particular bastion of financial and economic strength. However, we keep being told that gains in both currencies represent an element of fear for investors and reflect a move out of "riskier" assets and markets. It seems to be an all or nothing mindset — all risky trades are in favor when conditions are calm, while all are toxic at the first sign of trouble. Dubai may turn out to be a sobering reminder that quasi-sovereign defaults do occur, but it would seem wrong and naïve to treat all emerging market investments with suspicion because of this one occurrence.
Will We Have to Pay the Piper?
Even though I do believe central banks had no other choice and generally got it right in their response to the financial crisis and global recession it induced, they have increased the odds of creating more asset bubbles. Cheap, abundant money, coupled with low bond yields encourage speculative bubbles. We are already seeing signs of it in overheated Asian property markets and in the prices of some commodities.
We do live in a small and increasingly interconnected world. Global decoupling proved to be somewhat of a myth. Our economy stumbled under the weight of the housing and financial system meltdown and the rest of the world followed — we are, after all, the spender of last resort. Happily for all of us, other parts of the world have rebounded strongly and the rest appear to be following, though at a slower pace. However, recent events are a reminder that risks still remain and can impact all of us in the small world we inhabit. Perhaps gold at $1,200 per ounce is not a bad investment after all, in the event more bubbles are created, risk continues to be mispriced and lessons are not learned.
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