As we begin to develop an investment thesis for 2010 my suggestion is that we take a tabula rasa approach, as both investment theory and doctrine have been turned on their respective ears leaving most professionals to ponder everything from proper investment allocation to effective risk management and corporate governance. The uncertainty by investors is amplified by the incessant regulation and re-regulation along with the consequential consternation and uneasiness these seemingly endless procedures cause..and just like this sentence–we wish it would just simply end. The only certainty seems to be higher costs in legislative lobbying as groups seek to be either exempted or included. Washington wins again!
You can be certain there will be one key word of import in any concensus of investment professionals that will dominate the financial landscape in 2010: EXIT. From the exit of Central Banks from their quantitative easing programs which greatly affect valuations which have significant affects to the exits of institutional investors from existing investments, with private equity firms which will affect the IPO markets, Mergers + Acquisitions and the sales of partnership interests in the secondary market to sovereign funds and other institutional investors–see how it’s all connected? Those exits will define how the institutional investors escape or exit their respective unfunded commitments and effectively get liquidity for new investments (I will speak to those situations at length in a separate article on the private equity industry). In short, what’s at stake is a tremendous release of non-governmental liquidity currently pent up in illiquid investments. The combination of illiquidity and the absence of leverage have created the palpable obstructions to investments. The formula for the way forward will be recovery = equity + debt restructuring.
DEBT/ FIXED INCOME
A primary factor driving the push for exits is the $4.2b wall of debt concentrated between real estate and non-investment grade/leveraged finance. This will put considerable constraints on credit capacity and effectively reduce economic growth opportunities–further constraining investing. The lion’s share of the corporate borrwers are due in 2012 but these looming figures will still affect them this year. Approximately $2.7b of this debt is in various stages of real estate with $1.5b in leveraged finance–these amounts further complicate refinancing opportunities. To effectively meet these financing demands will require between $3.4 to $3.8b in refinancing capacity over the next 3 years–this will spur selling of assets (more IPO’s, Spin-offs, restructuring, recapitalizations) all which need the assistance of financial services. This will mean the investment banks will have plenty of work and are a good bet for steady income with cheap labor due to an enraged public keeping bonuses way below normal–current bank reporting notwithstanding, this is an excellent time to get back into this sector. Traditionally, some of this financing would have been done in the CLO markets –but with that arena being moribund currently, look for the high yield market to potentially double in volume. With over $1 trillion sitting in banks not being lent–that’s right, $1 trillion– and a number of banks actively turning away corporate money markets to earn 2%–look for active/robust activity in high yield by investment arms with a dearth of domestic investments for high returns. This will be key because corporate defaults typically are 13 percent and they have made up one third of the defaults last year with approximately $100 bn needing refinancing making this a critical area for finance. During the recession, both banks and insurance companies managed to provide over $300b in financing a year, this trend will most likely still occur and assist in absorbing some of the wall of debt over the next 3 years helping to mitigate potential default problems.
A key factor driving the economy is interest rates and we can predict that the Fed is highly unlikely to rise rates while unemployment is at 10% ( I predicted that the unemployment rate would rise over 10% last April for those keeping score), historically the Fed is reticent to do this unless unemployment is at 8%. Smart money will continue to bet on lower rates. This however weakens the Fed’s influence since it only has incremental room to push rates lower.
The prospects of exogenous shocks (read as a “je nais se quoi” term by economists to an unforseen/unknown event) and additional shocks such large defaults or of failed exits of monetary strategy would stimulate double dip fears and most likely cause panic selling–making these two factors highly important individually and collectively.
In terms of equities, the international demand for U.S. assets rose in November, expect this phenomenon to continue and for cash to continue to move into U.S. markets from points abroad as the U.S. continues to look like well infrastructured discount assets. Although, the record cash flow from the S+P is still half of the 2007 valuation after a 68% increase. The combination of low rates and re-allocation due to portfolio imbalances by institutional investors will continue to drive the market approximately 10-15% higher on relatively tepid performance–however having said that the consensus by investors, academics and economists alike is that we will see moderate growth in late 2010- some economists believe that the US recovery might actually slow down due to emerging market opportunities.
MERGERS & ACQUISITIONS
In terms of M+A, we are finally starting to see signs of life as sundry players have started to engage in transactions. As the year starts we see M+A veteran Tyco has agreed to buy Brink’s for $2B cash and stock along with agreeing to purchase Broadview for $1.9b, Swiss RE agreed to sell a block of it’s life insurance company to Warren Buffett for $1.3B for cash to improve its capital. To cap it all, the first buyout loan for 2010 is a $513m loan for Marken by private equity sponsor Apax–a sign of the warming debt market from the thaw–this will undeniably help to push loan rates higher. These factors are extremely positive for M+A activity, look for more deals to come as private equity firms seek to exit investments and return cash to investors.
INITIAL PUBLIC OFFERINGS
In the IPO market look for well-positioned, top tier companies to actively seek the IPO process while private equity firms push their sponsor backed deals through the capital markets. Industry leviathan Blackstone plans for a $2B London IPO of Travelport, while Carlyle begins preparation to IPO Moncler, a skiwear maker in London as well. IPO’s represent a channel for liquidity and from the looks of the backlog we can expect it to be fairly robust towards the middle of 2010. Global IPO markets are poised to have heavy volme as well, as can be deduced from the highly anticipated and equally controversial IPO of Rusal in Hong Kong which has Russian oligarchs waiting in line in London for their turn to be next. Turning eastward we see that Singapore has had 23 IPO’s already–this activity means that capital markets around the world will be on fire–making event driven investing a very exciting prospect.
The commodities markets will increase robustly as demand continues to increase (look for detail in my October commodities article for the specific reasons why), therefore transaction volume will dramatically increase in tandem, as the heat in dramatic returns has shifted to this investing sector. Look for the emergence of Forex being recognized as an asset class as institutions get more comfortable with that notion in a much more global world. The food supply will continue to tighten so look for grains to rise–weather fluctations notwithstanding. In terms of Oil, look to be short in the short term as investors will begin to take profits in the in the early 80’s but look for a price target of $90-95 for the year with traders taking advantage of the volatility and disparity of WTI in terms of gas.
The emerging markets trend growth in world GDP is 2.5% over the next 3 years. Emerging markets investment grade debt is now one notch above junk or high yield and is the primary factor that has fueled the $10.7b of issuance this year, despite the sovereign default fears brought on by Dubai. The higher returns will undoubtedly be found abroad in less developed countries where growth is a prospect and investors seek to ride the growth cycle of the respective countries. The emerging debt market is driven by the credit outlook of the individual countries and their respective resources and production values. Easy target investments for exposure into these areas are through the multi-nationals with accelerated organic sales due to their exposure to emerging market growth. A second way to focus on the growth of the country is to by the bonds for the target. I advise research and investigation of multi-nationals tied to infrastructure and distribution in countries that have resources or wealth, that can be quantified along with sensible rules and regulations. These prospective areas of investment should have valuations that are conventional and in line with current thinking–and not be based on speculative notions or bubbles. In other words, ones that are fundamentally sound with clear supply, production and distribution channels. Anything else might leave you holding the bag that someone else over prices–differentiation along these lines will be critical for profitable investing going forward.
We will next examine the area driving valuations and liquidity in 2010, no not banking–the Private Equity industry.