Sunday, June 11, 2006

What a difference a month makes

In the first quarter of this year I, along with many others, was filled with optimisim about the short to medium term outlook for the markets in which I was looking to invest. The only clouds on the investment horizon were the spectre of further rises in interest rates and the return of inflation in spite of which I went ahead and committed to purchase another small residential property (due to settle later this month).

In the space of about a month, things have changed dramatically. Equity markets in most countries have fallen significantly - declines of 10% or so from peak levels have not been uncommon. Precious metals have fallen by even more and the Hong Kong property market (at least for residential properties) has softened. Most significantly, investor sentiment has taken a knock.

The question I keep asking myself is whether what we are seeing is a short term technical correction or the begining of the next economic downturn. A quick and very unscientific look around town shows no obvious sign of a slowdown in business activity. An even briefer look over the border in China, suggests that there is no sign of a meaningful reduction in expansion. Significantly, China is still proceeding with the liberalisation of its economy (foreign exchange controls were eased again last week) and measures to cool an overheated property market are still in place (but underlying demand remains).

My tentative conclusion is that if there is a meaningful economic slowdown in Hong Kong, it will be a consequence of external factors. The obvious candidates are (in no particular order):
1.further increases in interest rates - the Fed and the ECB have both indicated that further rises are expected;
2.central banks tightening liquidity - having fuelled asset price inflation for several years we are seeing evidence that central banks may be starting to tighten liquidity;
3.consumer spending slowing down - increases in interest rates, falls in housing prices in some markets and rising costs of non-discretionary expenses like petrol have to have an impact on discretionary spending in other areas;
4.slowdown in the rate of capital formation/inflows - not sure about this one, but if economic growth slows it would be logical to expect capital formation to slow as well;
5.further increases in inflation - much harder to predict and assess. My long term view is that financially stretched governments have little choice but to inflate away a significant portion of their obligations. In the shorter term, a slowdown in the rate of commodity price increases and a tightening of liquidity (among other things) could slow the rate of inflation.

These are tangible items that are relatively easy to identify (although often after the event). Less easy to assess are changes in sentiment and confidence. Even harder to predict are event driven factors such as protectionist legislation, internatonal tension, terrorist attacks and medical pandemics - all of which have played a role in previous down turns - which are by their very nature difficult to predict both as to occurance and as to timing (remember SARS?)

I am starting to worry that we are headed for a global economic slowdown as opposed to just a shorter term correction in financial markets. If so, I need to formulate a strategy that will see me through the downturn and position myself to take advantage of the opportunities it will present.

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