Remarks by Andrea Heuson

Professor of Finance
School of Business Administration
University of Miami

Risks in the Financial Markets

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(SLIDES 1 & 2) One thing that we talk about in finance is the risk involved in committing money to some sort of a long term investment, the risk of commitment. It is sometimes called the term premium, or the illiquidity premium.  One way to measure it is the difference between long term and short term yields in corporate or government bonds. These are liquid compared to real estate so there’s an even bigger liquidity premium in real estate investments.

And we can also talk about default risk, and these days we have learned that there is your grandmother’s view of default risk, which is the difference between a nice safe corporation’s return and a treasury return.  Then there is your hedge fund manager’s view of default risk, which is significantly larger.  Probably the easiest numbers to use here are to compare returns on  a much weaker financial corporation versus a sound corporation.

So we can talk about the return required for commitment to longer maturity with no risk of default, we can talk about what return is required to tempt your grandmother to take her gloves off and plunge into some risky investment, or we can talk a little about what the high rollers want.

Tempted by Non-Traditional Investments

(SLIDES 3 & 4) If we look back to 2006 and 2007, growth in the US was slowing down, the dollar was weakening.  The term premium for long-term safe investments was negative, which is unusual. As far as committing to slightly riskier investments, investors got maybe a percent each for moving from governments into AAA or then moving into weaker corporates. That’s kind of a boring picture. It’s not surprising that people were tempted into some non-traditional investments if they wanted to get a little more interesting returns. As a result, we now have a new definition of a bear market, (a Bear Stearns market).

Wait until you see what the premiums looks like now after this wild ride of last fall.  I was teaching the financial institutions class this spring.  It was a lot of fun to be able to come in every day and say “Guess what happened! This has never happened before.”

Looking at the Term Premium

The dollar investors that are left are still pretty commitment-phobic as far as long-term investments are concerned but the default risk premiums are starting to come back to more  historical levels. First of all, look at the term premium. Look at what has happened to the difference between the yield on short-term and long-term investments. It has gotten incredibly high and it has stayed high and this is as of April 25, so we still have a significant premium to commit to a longer-term treasury investment. 

If we look at default risk from your grandmother’s standpoint, the AAA-Treasury premium is  starting to turn down a little bit, and it looks like maybe the rate of increase for more significant default risk has flattened, (the BAA – AAA spread). So it may be that people are thinking that US bond-type investments are safer than they were in early spring and last fall.

Impact of the Weak Dollar

(SLIDES 5 & 6) If you follow the international market, you know that the dollar lost 12.5 percent of its value versus the yuan, and 15 percent of its value versus the euro, (which puts a crimp in everybody’s vacation plans). And that’s got to have an impact on foreign investment growth here in the real estate market, into commercial, into residential, into vacation real estate.  I think what we are seeing is that the rate of increase in foreign investment has started to slow. I’ll show you graphs about that in a second.

The Current Account Deficit

Very, very preliminary data shows that the U.S. current account deficit, which is the money that we send out for all of the good and services we import is shrinking; it is getting a little bit smaller. It looks like just about $60 billion smaller in 2007 than it was in 2006. Now, that deficit of what we spend on imported goods and services is typically offset by investment flows into the country by foreigners, and when that deficit gets smaller the investment by foreigners tends to get smaller too. I’ll show you a graph of what I think that picture looks like. But, some other slides that will come a little bit later, suggest that maybe the foreign investment flows are shifting.  Instead of investment in stocks and corporate bonds and government bonds, perhaps some of the investment flows that are coming in are shifting into direct investment which is good for the real estate market, we hope.

That red line is our current account deficit and the impact of a weakening dollar is that the deficit is getting smaller.  We just can’t afford to buy as much from overseas. The financial account numbers, the green line, is now obvious. Those are the investment flows. But you can see that there is a pretty strong negative correlation there, so it doesn’t take much of a leap of faith to assume that the financial surplus is getting smaller at the same time that the current account deficit is getting less negative.

(SLIDES 7 - 10) Why do I think the 2007 numbers will show that there was some shift into direct investment from financial investment?  Let’s go back historically. You heard what nice returns there were in commercial real estate investments. In U.S. dollars, the financial investments picture is nowhere near as pretty. About a year ago we got about 5 percent or 4 ¾ percent on treasury investments, and inflation was not quite 3 percent, so you might expect a real return of about 2 percent. In Europe, the expected real return was about one-half percent.

Investors Now Standing on the Sidelines

So I go back to a year ago, and say, well, people who were thinking in terms of real returns, probably put their money in the U.S. because somebody who put their money in the U.S. picked up a little bit more than 2 percent increment in expected real return.  But if they stayed here for the whole year they lost 15 percent on the currency exchange when they went back home. 

If you’re interested in investing in different markets, it doesn’t matter if you’re a U.S. investor who said “gosh, I should have put my money in euros.” (My husband says “why didn’t you tell me a year ago to do this?”) It doesn’t matter where you’re from, you’re looking at this shift in currency values and you are reacting. Investors do not like weakening currency and my students will tell you that they can move money into any ETF in another currency instantaneously.

Investors do not like the weakening currency, and when there is a sign of weakening, they get out and their exit strategy becomes a self full-filling prophesy. Once they get out they don’t want to come back until they think that the currency that they are leaving has hit bottom.  So I think that we will see lots of evidence of people standing on the sidelines.

Inflation Higher than Expected

Something else that makes things even worse here is that between April of 2007 and April of 2008 inflation has been much higher than people had expected. Those announcements started hitting in January and in March. The Fed is lowering nominal interest rates with its rescue package and things, so the nominal rate is going down, inflation is going up and that is not a pretty picture for an investor. And we see that starting last fall, and continuing through this spring, there was a lot of outflow of stocks and bonds investments. But these numbers, these outflows if you add them up, are bigger than what I expect from a decline in financial account activity. So it may be that people are instead putting their money into direct investments.

If they are staying here they are moving into something like real estate, which has a longer term focus. You can look at appreciation numbers like we saw from Scott, and that appreciation may be enough to tempt investors to ignore the short-term pain of a weakening dollar.  The outflows are starting to turn around-- they are not as big in the last three months as they were last fall. And what is everybody watching is a series that always comes up in the Journal; it always shows up in all of these different articles. Finance people are not very good marketers or branders, so it turns out that we have the same theory but we give it about 20 different names. Sometimes it’s called the “trade weighted”, sometimes it’s called “the real value of the dollar”, (like there’s a fake value out there, somewhere). It is really an inflation adjusted value of a currency.

(SLIDES 11 - 13) Take a very simple example, suppose in the U.S. inflation is 6 percent, not that I’m forecasting or anything, and is 2 percent in Europe. Which currency should weaken? I think everybody is going to say the dollar should weaken, and to put you on the spot, by how much should the  dollar weaken?  Your first answer probably is about 4 percent because that is the difference in the inflation rates, and that is picking up purchasing power differentials.  So the dollar should  weaken by about 4 percent.

Well, suppose the dollar does weaken by 16 percent? The dollar is weaker than it should be relative to inflation. So it’s about 12 percent weaker than inflation says that it should be. That weakening is presumably caused by other risks besides inflation. And here we obviously have default issues and some other things that typically don’t come up. (In other countries we have blamed volatility in their markets on elections.  Clearly it’s a pretty nasty campaign here and until it is resolved eventually, the political question has got to lead to some uncertainty in this market.)

So if the dollar is weaker than inflation says it should be, in this particular example, it would be trading in about 88 percent of its real or inflation adjusted value. The Federal Reserve Bank of Atlanta, thank goodness, keeps these statistics. They have an army of interns. They follow about 30 different currencies and they create these indexes and they weight the indexes by the trade flows between the U.S. and each of these countries. So you can get data and time series from them. If a currency value or a pair of currency values is adjusted exactly for inflation, the value of this index would be 100 percent. Well, here is the value of the dollar versus the Americas, which is Canada and Latin America. Moving from a significant over-evaluation in the early part of the decade, the dollar is now undervalued, not by much, but it has been undervalued for probably the past year.

Compared to Europe, which started at a higher overvaluation, we now have a significant undervaluation relative to Great Britain, the Swiss, and the European countries. And look, the dollar is almost at parity with the Asian continent, which has got to drive them crazy, because they are so dependent on their export markets.  By what I read, maybe starting in the fall, the effect of that undervaluation in the dollar was a continued promotion of our exports. It has to help all of those businesses that compete with imports. I can’t park on South Beach, and the hotels are completely full.

Dollar-based multi-nationals that have foreign profits are also helped by the weak dollar. Warren Buffett has been quoted as saying his recent strategy is to put his money into U.S. firms that earn a lot of their profits overseas. And that undervaluation has got to help people who are selling investments and vacation real estate.  The hope, anyway, is that by the fall we will be back to more normal market conditions.

(SLIDE 14) As the U.S. economy starts to recover, the dollar will start to strengthen. The investors are going to start to come back into the portfolio investments, (stocks and bonds).  When they start to come back their trading becomes a self-fulfilling prophesy and you start to get a lift in the value of your currency.

(SLIDES 15 - 17) At the moment, it is still not a pretty sight, as far as dollar bond investments are concerned. Over on the right hand side, those are nominal interest rates. One year, very safe investments in the dollar are at the top, Canada, Great Britain, Europe, in the middle, those are kind of developed comparisons, and our emerging markets are at the bottom.

The second column is inflation, most recent inflation, in each of those countries, and you can get an estimate of the real return over on the far right column just by subtracting. There is still a negative real return in U.S. portfolio investments at this point. It’s slightly higher in Canada and Great Britain, it’s about zero in Europe and it’s significantly larger in Brazil, Mexico, and Columbia. But those are emerging markets that are significantly riskier.

If you look just at the difference at the nominal interest rates, that is the return to something called the carry trade. This is something that the Japanese have been famous for doing, which is borrowing in a low interest rate country and then investing in a higher interest rate country and hoping that nothing changes. That’s a pretty risky strategy but there are lots of people who think that carry-trades are investments worth pursuing. It is just the kind of thing that a hedge fund might do and then watch the markets every day and just hope that things don’t shift. If you are brave, but not too brave, you can use the forward market to buy your home currency back when you repatriate your expected investment profits. The currency dealers will take part of your  return from you. They won’t take it all in most cases, but they will take part of it from you because they know that they are giving you some insurance.

And then over on the far right, is the return that is left from this sort of a synthetic strategy, of borrowing dollars, investing in one of these countries and re-converting back through the forward market. Those synthetic premium numbers are typically about zero versus developed countries between the U.S. and Canada or the U.S. and Great Britain, and they are typically about 2 percent in emerging markets.

Now I never thought that I would see this, but European bond investors can stay home and earn 50 basis points. So at this point they don’t have any particular reason to come back to the U.S. The Canadians can stay home and get about 60 basis points more.  Mexico is about 1½ percent safer than usual. Columbia is about 1 percent safer than usual. The risk level is between the U.S. and Brazil is about 2 percent which is the only country that is at the normal level so we are still not back to typical conditions in the U.S. market.

(SLIDE 18) My conclusion from all of this? I’m very glad I have a nice safe teaching job and I don’t have to work in these markets every day. Wait it out, fall should be better.