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Investor Confidence Commentary

Date: Tuesday, November 24, 2009
Author: Andrew Capon, State Street Global Markets

Investor Confidence Commentary
24 November 2009
Andrew Capon
State Street Global Markets
Balancing act

Thirty-five years ago Philippe Petit walked between the twin towers of the World Trade Center in New York on a tightrope at a height of 1368ft. He explained, “When I see three oranges, I juggle; when I see two towers, I walk.” This phlegmatic attitude to risk served Petit well. “The Artistic Crime of the Century” as Time Magazine dubbed his walk made him an instant global celebrity.
Institutional investors have been rewarded for risk seeking this year. State Street’s Investor Confidence Index (ICI) reached a nadir soon after the collapse of Lehman Brothers but investors started to add to risk this April when the index breached the crucial 100 level. The ICI remains above 100 this month but has fallen 22 points from its August high. The balance between risk seeking and risk aversion has become very fine indeed.
Prices and flows present a similar picture. Stock markets have struggled to hang onto their recent highs.  Monthly cross-border flows into developed markets have stayed below their long-run median during November. In emerging markets, monthly flows have dipped from the 75th percentile to the 55th. This is the lowest reading for cross-border emerging market flows since the start of the risk rally in April.
This may be particularly significant as it was the recovery of flows to emerging markets that foreshadowed the broad recovery in risk appetite and cross-border equity flows. However, it should perhaps not come as a surprise. The MSCI World Index is up 26.7% year-to-date but it lags the return from emerging markets by 46%. The MSCI BRIC index is up an impressive 91%.
There is evidence that a broad asset allocation shift with a bias toward value has started. Among developed markets the strongest monthly cross-border flows are into Japan.  It has been one of the weakest performers over the past year, underperforming the global index by 25%. A strategy of buying beta (stocks highly correlated with the market) has just suffered its worst month since the start of the risk rally in March.
During the first six months of the previous three post-recession rallies in 1982, 1990 and 2003, beta has outperformed by an average of 10%. In this rally it outperformed by 30% before sharply underperforming in November. Flows suggest that institutional investors are now favouring sectors with low equity multiples and below average earnings forecasts.
FX flows also point to investors taking their profits in risky currencies. For example, they are aggressively unwinding an entrenched long position in the New Zealand dollar. FX flows are no longer correlated with yield. Having built long positions in currencies such as the Brazilian real, investors are now selling. The absence of carry trades further evidence of risk appetite moderating.
Though policymakers continue to make reassuring noises about not withdrawing stimulus any time soon, investors recognize that ultra-easy policy cannot last forever. The unprecedented actions taken to avert a second great depression worked. But this radical policy prescription is somewhat akin to Monsieur Petit’s high wire act. One misjudged move could prove fatal.
There are concerns about inflation, deflation, the indebtedness of governments, the true condition of the financial system, the durability of Chinese growth, the health of US consumers; the list is almost endless. Against such a backdrop, it would be remarkable if risk appetite and markets recovered in a neat, linear fashion. As the year draws to a close, investors have decided to take a more balanced approach to risk seeking.