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It has been a testing first quarter, which has been an opportunity to increase equity weightings and reassess our cautious bond view. We have increased weightings in Asia and Europe and believe in the longer-term prospects for yen appreciation.

Several events have conspired recently to cause equity markets to react poorly. First, news that the Chinese authorities were imposing controls to stamp out illegal speculation was met by a 9 per cent fall in the local market. Second, former Federal Reserve chairman Alan Greenspan suggested recession was a “possibility”. Third, news emerged that some of the most over-borrowed US consumers were unable to make interest payments, resulting in several bankruptcies of over-aggressive lenders.

Chinese measures to ensure stability must be applauded and in many ways their gradualist approach to capitalism is serving them well. Not to have acted in this manner would have threatened longer-term prospects for the country.

Greenspan’s observation that growth is slowing is not news. This is the first in four years that earnings growth will be below 10 per cent but this is already known by the market. We must not forget earnings are still growing. As Greenspan indicated afterwards, recession is always a possibility but not probable at this stage.

More significant is the importance that should be attached to increasing mortgage defaults. The foundation of consumption is debt, which has relegated the concept of saving as obsolete. Who needs to save when you can borrow?

While the world is stable and interest rates low, such notions gain popularity. The worrying aspect is that the conditions on which debt can thrive – low interest rates and stability – are present today. Just how over-leveraged are US consumers if they cannot service their obligations in this environment?

If this were the start of widespread defaults, the ramifications would be retrenchment of US consumption, driven by a desire to increase savings and pay off obligations.

Events such as the bankruptcy of some notable lenders, due to unsound lending practices, have a tendency of being extrapolated to the worst extent. History shows that such events seldom reach their worst extreme, as markets do what they can to ensure this does not happen. Is this the start of something more sinister or are the defaults in debt servicing contained to a particular segment of the overall loan market? We believe they are contained.

Consequently, increased volatility in response to these concerns were, in our view, an opportunity. Widespread selling of shares has made valuations more reasonable, interest rates have broadly fallen, providing a further incentive for institutions to merge or make acquisitions, and there are many more people out of the market than there were only a matter of weeks ago. These investors are now latent buyers.

This provided us with all the excuses we needed to increase weightings in the engines of growth – Asia and Europe. These events did not affect equity markets in isolation. As stability was perceived to be threatened, investors looked to reduce risk. Bonds rallied modestly but now look extremely vulnerable. The real highlight was widespread conjecture that the yen carry trade was being unwound. This means that people and institutions that have financed their investments with loans at attractive interest rates denominated in yen will close that loan and repay yen.

We believe in the longer-term prospects for yen appreciation but until there is a genuine risk to global stability, accompanied by a belief that Japanese interest rates are on the rise, there is little motivation to close out these loans. We suspect recent yen strength is not an unwinding of the carry trade and there are more Japanese investors looking to find yield in foreign markets.

Nick Wakefield manages the Ashburton international equity fund.


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