Market Updates and Investment Trends: Where the Money Is Going

6 November 2008

Given current market upheavals, which core themes do investors concern themselves with? And what investment stance will they take on different assets when normalcy returns to the markets? In short: Where is the money going? A new report, Market Updates and Investment Trends: Where the Money Is Going from Celent, a Boston-based financial research and consulting firm, examines how the main asset classes and investor pools have responded to the unfolding crisis and what the future holds for them.

Key findings of the report include:

• All asset classes will remain on the table post-crisis, but demand for new, complex structured products will be limited. Instead, the dominant theme is the right asset for the right investor, with an investment structure tailored to the underlying liquidity situation and investor's time horizons.

• Liquidity and risk premium were significantly undervalued leading up to the crisis. Liquidity has been taken for granted. That cannot be the case any longer. Investors will demand an appropriate premium for illiquidity.

• In the past few months, an almost unprecedented crisis of confidence occurred in the previously rich valuations of global equities in developed markets. A market bottom is difficult to predict, but even the most bearish global commentators expect stocks to rebound from their recent lows to higher valuations. However, equity valuations will not reach the levels seen in recent years any time soon. The US economy, and with it global economic growth, cannot realistically be expected to rebound within the next few quarters. A severe recession will make equities less attractive than other investments. While equities have lost relative popularity as an asset class in recent times, equity options have risen in popularity and may supplant equities in some instances as an asset class in which to find and deliver superior returns.

• The bond market will struggle to shake the impact of the credit crisis. Not only will weakness in the housing market continue to adversely affect the mortgage-backed securities market and other highly structured bonds; Celent also expects spreads between US Treasuries and corporate bonds to remain elevated, as investors remain anxious about assuming risk. Yet discriminating investors can still find value in strong corporate bonds, in particular non-cyclical consumer industries. The credit crisis does not spell the end for the structured credit and securitization market, but the shape of these markets is likely to change: they will be smaller, but still significant, and use simpler structures.

• Despite the current difficulties, Celent is optimistic for the foreign exchange market , which should see continued growth. FX will not be able to expand at the same rate as it has in recent years, as there are fewer market participants from broker/dealers winding down or merging. Moreover, the end of easy credit is likely to hinder the flow of business from margin traders. There is, however, widespread optimism that the fallout can be somewhat compensated by retail investors becoming an integral part of the FX world. Moreover, the fundamentals of FX-continuing globalization of the world economy, growth of emerging markets and further sophistication in derivative products-as well as its limited balance sheet impact present significant capacity for growth going forward.

• Due to the prospect of lower global growth for the remainder of 2008 and 2009, Celent anticipates tough markets and tremendous volatility for most of the commodities sector in the near future. Furthermore, the biggest speculators and lenders in the commodities markets are those that are caught in the turmoil of the credit markets. Yet, the long-term picture remains bullish for commodities. Notwithstanding the recent pull-back, the forces that led to the recent bull cycle look set to continue: The macro trend of rising commodity demand, supply-side constraints, and inflation, as well as the entrance of institutional investors, will make the fundamentals of these commodities stronger in the long run. Investors must be mindful of the strong cyclical qualities of the asset class and the distinct structural drivers behind different component assets. Therefore, investments strategies must be active, not buy-and-hold, because market timing is critical to continued success in the commodities market.

• Despite the current, rather bleak picture, Celent's long-term outlook for emerging markets (EM) is bullish. The underlying story for EM going forward is the growing purchasing power of rapidly expanding middle classes, notably in China and India . However, the credit crisis has shown that investors must be wary of the "de-coupling" sales pitch, because both the developed world and commodities remain strong influencers. Thus, investors should not view diversification and uncorrelated beta as the primary purpose of an emerging market investment. Instead they should see them as a source of new returns (and new risk). EM should be seen as a heterogeneous continuum-from the least developed to the most developed. There is considerable grey area and considerable differences between the drivers.

• While the credit crunch adversely affected parts of the OTC derivatives markets, notably credit default swaps (CDS), listed derivatives have fared relatively well. The growth of volumes in these instruments is considered a direct function of the heightened concern with counterparty risk. But while OTC markets are likely to take a back seat to listed derivatives in the near future, Celent believes that both markets will coexist in the long-term, because they cater to different needs and different players. Due to heightened regulatory pressure, however, the migration of some OTC market activity to central clearinghouses and ultimately to official exchange platforms will gain momentum.

• Demand for new assets is strong, driven by the search for value and uncorrelated returns. Yet new assets must be viewed individually because the term encompasses markets at vastly different stages of the development cycle in terms of their available supply and market development. Distressed debt and infrastructure are believed to be at the forefront of emerging assets as a result of ample supply and heightened interest among a wider range of players. Niche assets, such as freight, microfinance, longevity, and reverse mortgages, will be bought by natural participants, hedgers, hedge funds, and a subset of institutions looking for diversification.

• The retail investor segment (especially the mass retail or middle class in many of the emerging markets) is certain to grow in importance, sophistication, and demand. Today's retail investors are more active and increasingly pursue high yield strategies to support longer life spans. Sovereign wealth funds will be an increasingly important asset pool going forward, as they are growing in both size and sophistication, and (with cash flows growing significantly) are increasing their allocations to nontraditional asset classes. Although hedge funds have been hard hit by the credit crisis, Celent expects the industry to rebound in the longer term. The main challenge for the industry going forward is to deliver on the alpha promise, because leverage has been removed from the game like never before. For long-only investors, the push into alternative instruments, strategies, and vehicles currently seems somewhat out of tune with investor sentiment. Investors will have stronger risk aversion for a year or two to come, which means we will see a period of greater financial conservatism in asset management.

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