Global Agenda: What's quality?

Despite concern that a severe and prolonged decline in equity markets is probable, I still lean toward the correction camp.

money good 88 (photo credit: )
money good 88
(photo credit: )
The shakeout in the global financial markets has continued, with the post-holiday weekend in the US and UK seeing another hefty bout of selling around the globe. The question posed here two weeks ago - Is this the start of a major reversal and downturn, or only a short, sharp and unpleasant "correction"? - is still very much on the table, and is the subject of intense debate across the global financial community. Despite - or perhaps because of - this column's oft-repeated concern that a severe and prolonged decline in equity markets is probable, I still lean toward the correction camp. If indeed there's going to be a "big one," this ain't it. Last week, for instance, the US markets actually eked out a small gain over the week. The media trumpet that this or that index has now "lost all its gains for 2006" - unfortunate for those who got in late and unpleasant even for those who got in early, but hardly the end of the world for anybody. What does seem to be happening is that a lot of the hot air contained in the emerging markets balloon has been abruptly released. Many investors - including the Israeli investing public, who were foolishly led by the Pied Pipers of the mutual fund industry into the "BRIC" (Brazil, Russia, India, China) wonderland in January and February - have found their trip to exotic and faraway investment destinations expensive and somewhat traumatic. In passing, it is well worth noting that the Israeli markets - currency, equities and especially bonds - have weathered the recent storm exceptionally well by any relative measure. The reason for this is rather simple, although many Israelis have failed to grasp what foreign money managers see clearly: The Israeli economy is performing very well, its fundamentals are strong and likely to remain so and its prospects are good. The financial markets are reaping the benefits of the series of reforms completed, underway and planned, which are changing it out of all recognition. But that's a local aside. In the wider global picture, the dominant phenomenon is, as always in this situation, the "flight to quality." This means moving from riskier and more speculative investments to those deemed safer and less prone to sharp swings in price. The safest and most solid investment is cash and cash equivalents such as bank deposits. Government bonds are usually next on the list. However, it is becoming apparent that flying back from low-quality investments to high-quality ones is not as straightforward as it used to be. Quality is a very relative term, so that although US government bonds are universally considered higher quality than Indian shares, the choices within the "high quality" department are actually quite difficult. The greenback - for the last 60 years widely referred to as "the almighty greenback" - is under pressure and almost universally expected to lose (further) value relative to other currencies. The euro is increasingly seen as a substitute but, when buying euro bonds, you have to be careful to avoid bankrupt and dysfunctional parts of Euroland, such as Italy, in favor of more attractive and better managed countries. Japan, the other major developed economy, is not considered a potential safe haven by most non-Japanese, least of all via its bond market. The unease and outright suspicion pertaining to each of the largest economies explains why the gold bugs have re-emerged in force, and why they are gaining a better hearing than at any time since gold prices collapsed in the early 1980s. The basic argument in favor of gold is that it cannot be debased or undermined by incompetent, venal or stupid governments. On the other hand, gold pays no interest or dividends and its record is one of massive price swings. But when fear is on the rise and confidence in governments and in the entire global market system is on the wane, gold can seem very attractive - it can certainly be made to seem that way and, when the bandwagon is rolling nicely, everyone will jump on board. The recent abrupt $100/oz. fall in the price of gold shook out many of these bandwagon-jumpers. But gold's role is fundamentally different to that of the exotic equity markets so that, unlike them, it is probably only in mid-journey with quite a way to go yet.