When rock stars buy…
David Rubinstein, managing director of Carlyle – the private-equity pioneer made famous by Michael Moore (though not in a way it likes) – said this to the assembled buyout superstars at Frankfurt’s “Super Return” conference this week:
“Now rock stars want to be private equity people. When rock stars are getting into our business, you know we’re at the top of the market.”
I’m not aware that anyone has rushed to defend Bono’s investing credentials. But actually you can apply Rubinstein’s remarks more broadly.
For years now, there’s been a torrent of cash pouring into hedge funds, private equity or any financial instrument apparently promising better returns than high-grade corporate or government debt. And the torrent has been turning to deluge.
So the volatility we’ve witnessed in global equity markets this week is simply the most conspicuous manifestation of widespread fears that we may be near the peak of this particular cycle.
In an era of relatively low inflation and low interest rates, the great markets trend of the past decade has been the so-called “search for yield”. That’s why private equity and hedge funds have boomed: they claim to offer super-normal returns.
It’s also precipitated a massive cross-border financial practice called the “carry trade”. This is the business of borrowing where interest rates are incredibly low – such as Japan, where the benchmark interest rate is half a per cent, less than a tenth of the British base rate – and investing the cash in instruments promising decent yields (in theory) such as emerging market bonds or corporate junk bonds.
The scale of the carry trade has been such that the price of genuinely toxic bonds – and potentially poisonous financial instruments issued by private equity to fund their purchases – have been driven up to levels where they don’t yield much more than really safe investments, such as US or UK government bonds.
Or to put it another way, substantial risk has been under-priced: investors have been behaving as though we live in a risk-free world.
That’s unsustainable. And when risk is under-priced, it only takes a smallish rise in expectations of risk for near-panic selling to ensue.
This is what happened this week, after a number of anxieties surfaced. First the sharp drop in the Shanghai index showed that financial assets in the fast-growing super-charged economies of China, India, Brazil and so on can go down as well as up.
Also – and probably more importantly – the value of the yen has been rising. So anyone who’s borrowed a load of yen and converted it into another currency suddenly found that the repayment cost has gone up.
Now in those circumstances, some yen borrowers will have tried to liquidate their portfolios of high yielding assets, such as junk bonds or emerging market debt or arcane products such as collateralised debt obligations. But the thing about these seductively high-yielding markets is that they often become horribly illiquid when everyone wants to sell. So investors are instead forced to sell the stuff that can be sold – which is why the price of blue chip UK and US stocks has been falling.
Finally, there have been worries for some time that the US housing-market bubble has been pricked and that there will be horrendous losses for sub-prime lenders or those who’ve lent to house purchasers who couldn’t raise conventional finance (such as our own HSBC, which has recently disclosed losses greater than had been expected and will doubtless disclose more about its US woes in its results on Monday).
The sub-prime market is enormous. But what the investment bankers I spoke to this week are really concerned about is the possible spread of losses from sub-prime to higher-quality home loans and a consequential collapse in consumer spending.
What was that about living in a risk-free world?