Merrill Lynch Fund Manager Survey Finds Chinese Economic Optimism Fuelling Improved Growth Outlook

/PRNewswire/ -- Fresh optimism over China's growth prospects has led to a marked improvement in economic sentiment globally, according to the Merrill Lynch Survey of Fund Managers for February.

Investors are at their most hopeful about the year ahead since the credit crunch took hold in July 2007, with the number who forecast a worsening economy in the 12 months ahead falling to a net -6 percent. This compares with a net -24 percent in January. The majority recognises, however, that the world economy is in recession.

Fears of a prolonged slowdown in China appear to be fading. The number of investors who predict lower growth in China over the coming 12 months has fallen sharply, to a net 21 percent in February from a net 70 percent in January.

Similarly, severe pessimism about the outlook for corporate earnings has started to ease. A net 43 percent of respondents expect to see deteriorating profits over the coming year, significantly lower than the 63 percent who held that view in December. A net 49 percent of the panel predicts inflation will fall over the coming 12 months, compared with 64 percent in January and 82 percent in December.

"Fund manager expectations for Chinese economic growth rose dramatically to their highest levels since 2007, and faint global decoupling hopes now reside solely with China," says Michael Hartnett, chief Global Emerging Markets Equity strategist at Banc of America Securities-Merrill Lynch Research.

Commodities coming back as equity allocations shift into cyclicals

Commodities have enjoyed the sharpest pick-up in terms of changes to asset allocations in the past two months. Investors hold a net 15 percent underweight position in commodities, down from a net 32 percent underweight in December.

Bond weightings were trimmed while equity allocations fell back to a net 34 percent underweight - the same position as in December. Investors have been pruning back their allocations to traditional defensive sectors and moving into more cyclical sectors.

Weightings fell in Telecoms, Insurance, Staples and Utilities. At the same time investors increased positions in Technology, Energy, Materials, Industrials and Discretionary Spending.

"Higher risk appetite, rising commodity sentiment and a strong valuation case could encourage further investment in energy and materials sectors. We see this as best played out through sterling-denominated assets," said Gary Baker, Banc of America Securities-Merrill Lynch head of EMEA Equity Strategy.

U.S. in favour while Japan allocations fall

Appetite for U.S. equities has been reawakened in February, possibly boosted by poor market performance in January. The net overweight position in U.S. equities has risen to 15 percent this month, up from 7 percent one month ago. The U.S. benefits from having the best profits outlook, and 31 percent of respondents want to overweight U.S. equities in the next 12 months.

At the same time allocations to Japan have fallen starkly with investors who hold a net underweight position of 26 percent, compared to 15 percent in January. Traditionally, Japanese equities would benefit from a broad pick-up in sentiment. Japan also suffers from having an overvalued major currency, according to the survey.

For the first time, respondents view the yen as more overvalued than the euro. Pessimism over the euro has broadly moderated, while the region's macro-economic outlook is somewhat more favorable.

"Eurozone growth expectations picked up to the highest level in 12 months in February," said Baker. "But in contrast with the global picture, the number of European portfolio managers overweight cash spiked to the highest level since October 2001."

Survey of Fund Managers

A total of 212 fund managers, managing a total of US$599 billion, participated in the global survey from 6 February to 12 February. A total of 177 managers, managing US$372 billion, participated in the regional surveys. The survey was conducted by Banc of America Securities-Merrill Lynch Research with the help of market research company Taylor Nelson Sofres (TNS). Through its international network in more than 50 countries, TNS provides market information services in over 80 countries to national and multi-national organizations. It is ranked as the fourth-largest market information group in the world.

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What's Ahead for U.S. Financial Institutions?

When Barack Obama is sworn in as the 44th U.S. president on January 20, he will inherit a weak economy that has helped to effectively put some Wall Street companies out of business while driving bank failures to the highest level in more than a decade.

From Knowledge@Emory

At the very least, financial institutions can expect increased government scrutiny, according to faculty from Emory University’s Goizueta Business School. The challenge, they add, will be to refrain from strangling the financial system with over-regulation.

The number of failing financial institutions is sobering, and includes the wind-down of Lehman Brothers, Merrill Lynch’s rushed sale to Bank of America, Bear Sterns’ sale to JP Morgan Chase and the failure of 22 banks as of November 21, to 22, according to a running tally kept by the Federal Deposit Insurance Corp. Numbers like that have not been seen since 1993 when 50 banks fell, according to FDIC records.

“In the past few years Wall Street made an incredible amount of money by taking on enormous leverage,” says Jeffrey A. Busse, a professor of finance at Goizueta. “But it is now clear that the risk they took on was not fully understood.”

In the wake of the current financial disaster, there’s likely to be a lot less appetite for the kind of high-leverage merger and acquisition deals that helped pave the way for an eventual credit crunch, adds Busse.

“Along with the pullback in leverage, we’re likely to see stepped-up government regulation of banks and other financial institutions,” he says. “When companies ask for federal bailouts, they’ve got to expect the funds will come with some strings attached.”

Some banks in particular initially benefitted from issuing sub-prime and other exotic loans, but suffered significant losses as the housing market collapsed, Busse notes.

“Even after this crisis subsides, banks are likely to record lower revenue as a result of tighter lending standards,” he says. “Further, this credit crunch may last for some time, and more loan restrictions will likely lead to slower growth in the economy over the long term. That might not be so bad, though. Years of easy-money policies meant that too many people got used to living beyond their means. They didn’t realize that you can’t do that forever.”

Financial markets and institutions are changing in significant ways, observes Tarun Chordia, a chaired professor of finance at Goizueta.

“With the decision by Morgan Stanley and Goldman Sachs to reorganize as bank holding companies, there are essentially no more standalone investment banks,” says Chordia. “That means their proprietary trading desks will not be as active and we’ll see a disappearance, or at least a significant curtailment, of the huge bets on markets that once characterized Wall Street.”

Chordia says banks are likely to face stiffer capital requirements, especially as the government pumps public money into financial institutions.

“Banks are likely to be required to watch their liquidity very carefully, and derivative markets will also face more scrutiny,” he says. “For instance, we are likely to see more transparency in the credit default swap market which is more likely to move towards an exchange market with appropriate constraints on counterparty risk.”

However, he notes, the financial crisis has led to a “suspension of the debate” about the appropriate level of regulation of markets and institutions.

“Risk taking by banks is likely to undergo some significant tightening,” Chordia adds.

”More regulation is coming and maybe some of it is necessary but too much regulation can also be harmful to the economy. It is important to strike the right balance so as not to endanger the innovativeness and the creativity of the U.S. economy. The optimal rate of bank loan defaults is not zero.”

As a society, says Chordia, there is a question of whether there should be tighter constraints on the ability of financial institutions to take on risk. Too much regulation can drive activity to other international markets and harm America’s standing as an international financial center, he observes.

“The economy would have suffered if over-regulation had strangled Silicon Valley,” warns Chordia. “Let us remember that Google, Apple, Cisco and countless other firms were started in the U.S. and the risk taking ability of the financial institutions was an important ingredient in their creation.”

Chordia is somewhat concerned about solving that conundrum. “We need some regulation,” he says. “The trick is to strike the right balance, and I believe that [U.S. Federal Reserve Chairman] Bernanke and [U.S. Treasury Secretary] Paul Paulson seem to understand the situation. However, I am concerned that with one party in control of the executive and legislative branches of the government we might see some excesses. Gridlock may have been better.”

“In the long run, regulators should strengthen the partition between tax-payer underwritten portions of a bank’s operations and other operations,” according to Narasimhan Jegadeesh, a chaired professor of finance at Goizueta. “One set of banking operations, for example customer deposits, have a government guarantee and are subject to strict regulations regarding investments. The other assets of banks are not as highly regulated because they have no government guarantees. The government guaranteed operations of a bank should be solvent on a standalone basis, but in the current environment troubles in the non-banking operations are hurting banks’ ability to support their deposits.”

Today’s financial crisis has been exacerbated by the repeal of the federal Glass-Steagall Act in 1999 [a 1933 regulation that prohibited commercial banks from collaborating with full-service brokerage firms or participating in investment banking activities], he adds.

“Glass-Steagall was repealed in order to let banks compete better with other financial institutions,” explains Jegadeesh. “The problem is it let banks take more risks, but used taxpayer funds [through the FDIC, for example] to guarantee their continued existence. Government-sponsored entities such as Fannie Mae and Freddie Mac also took on risks far in excess of what could be supported by their capital base because of implicit government guarantees.”

Giving an institution explicit or implicit government guarantees is inherently dangerous because it encourages “moral hazard,” or undue risk-taking, he explains.

Fannie Mae and Freddie Mac, which were created to help increase the availability of residential mortgages, were recently seized by the government over concerns about the sharp increase in failing mortgages. Regulators did not fully understand the extent of risks they were taking until very recently.

Similarly, the Community Reinvestment Act, enacted by Congress in 1977, was intended to facilitate homeownership by the economically weaker section of the Society. CRA encouraged banks to extend credit to residents of local communities who might otherwise not qualify for home loans.

“It was a noble goal, but it effectively forced banks to extend credit to people who could not carry the debt,” says Jegadeesh. “I believe the incoming presidential administration will have no choice but to ease up programs like the CRA, although it will likely do so in a politically proper manner.”

As politicians ponder their approach, they would do well to consider the way their actions are likely to affect market liquidity, says Kevin Crowley, a lecturer of finance at Goizueta.

“They may be tempted to hammer away at hedge funds and other institutions, but over-regulation could drive money to other countries,” he notes. “Something similar happened after Congress passed the Sarbanes-Oxley Act of 2002, which imposed more rules on publicly held companies. Some foreign companies decided not to list on U.S. markets, and there was an increase in the number of public companies who voluntarily delisted as a way to escape the additional reporting costs associated with Sarbanes-Oxley compliance.”

But with a Democratic Congressional majority and a Democrat in the White House, Crowley sees little chance of a retreat in financial regulation.

“Many kinds of players contributed to this financial meltdown,” says Crowley. “But politicians generally find it easier to blame banks, hedge funds and speculators than to admit their own role. The concern now is that the regulatory pendulum may swing too far and possibly choke off a recovery.”


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Private Equity Leaders Confident of Full Economic Recovery

/PRNewswire/ -- Over half of private equity leaders are confident that the full recovery of the market is no more than 18 months away, new research commissioned by Celerant Consulting reveals.

A survey of more than 220 senior executives across Europe and the United States, carried out by the Economist Intelligence Unit, reveals that 53% of private equity leaders believe that the market will return to its pre-credit crunch levels within 18 months. The findings showed that US executives are more optimistic about the future than their European counterparts, with 62% of US respondents believing that a turnaround would occur within that time frame. As noted, the global sentiment was a bit more pessimistic, with 36% of UK and 32% of German respondents predicting a full recovery would take longer.

Paul de Janosi, Managing Director of Private Equity, Celerant Consulting, said: "Despite the optimistic viewpoint of a majority of the survey respondents, we feel that it will be a few years before we see pre-credit crunch levels of activity again. We expect the roots of early recovery to begin in the second half of 2009, leading to broader activity by mid-2010. The GP's will not be static though, as there is significant amount of portfolio remediation work and this type of market down-turn typically yields strong buying opportunities."

Yet to hit rock bottom?

Despite the long-term optimism, many of those questioned still felt that the market has further to fall. The vast majority believe both the volume and value of deals will reduce over the next year (78% and 81% respectively), whilst two thirds (66%) say they intend not to invest at the moment and would instead wait for more attractive deals.

Change is necessary, but how?

The survey also found that private equity leaders from around the globe are united in the belief that the credit crunch and subsequent recession will transform the industry, with 96% agreeing that PE firms will have to change. However, there is no consensus on what the sector will look like when the credit crunch has passed, highlighted by the fact that 16% acknowledge that there will be a need to change but they are not sure how.

One fifth thought that the industry would need to find a completely different financing model -- unsurprising given that the reduced levels of available credit in the marketplace means that the days of massive leveraging are a thing of the past. Almost as many, 19% globally and 29% US, expect the credit crunch to lead to consolidation within the private equity sector itself.

What to do in the meantime?

Nevertheless, despite acknowledging the need for change, only 20% are planning to scale back activity in the next 12 months, and a mere 2% intend to shed jobs. Rather, the optimistic long-term prognosis is illustrated by the fact that 26% of those questioned are prepared to take on new staff.

Paul de Janosi continued: "The credit crunch means that easy refinancing is a thing of the past, yet the private equity industry is still optimistic about the future. In the short term private equity companies have already begun to shift their focus from investment to improvement. They need to concentrate on their existing portfolios to ensure that they are both maximising their operational efficiency for short-term survival, and guaranteeing long-term growth."

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