Merrill Lynch’s Richard Bernstein is one of the few investment strategists on Wall Street whose writings are worth paying close attention to. Back in January, for example, he wrote this about how financial markets would eventually be shaken from their complacency:
We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe that nothing is happening. The initial pop seems like a random event until a second occurs. A third. A fourth. Then the popping goes wild.
That’s a pretty good description of what happened over the subsequent eight months. So what is Bernstein saying now that everybody else is focused on the popping popcorn? This is from his Monthly Investment Review, published today:
We … have noticed what the headlines are not saying: asset returns have followed the textbook pattern as volatility has gone up. Treasury bonds have begun to outperform stocks, high quality stocks and bonds have begun to regain leadership, and developed markets have started to outperform emerging ones.
Today’s noisy headlines also ignore the reality that volatility accompanies change. We doubt that the leadership stories of the past five years will be the leadership stories of the next five years. In this month’s Investment Overview, we explain why the market’s increasing risk aversion and the rising cost of capital mean that many of the capital intensive investment stories that have been leaders for the past few years are likely to underperform. The next multi-year investment story is likely to be higher quality, less capital intensive, and centered in the developed markets. As the investment waters become more turbulent, savvy investors will need to remember that volatility signals change and opportunity.
A bit deeper into the piece, he writes:
Some observers have suggested that the credit market’s present problems are solely a subprime mortgage issue or solely a US issue. That is not the case. The global credit markets are beginning to re-price risk, and the cost of capital is increasing around the world.
By definition, companies that use the most capital will be hurt the most as the cost of capital increases. So-called capital intensive industries depend heavily on cheaper borrowing costs, whereas companies that don’t borrow are generally unaffected by rising borrowing costs (of course, one must consider whether those companies’ customers are borrowing to buy the companies’ goods).
Bernstein then lists six capital-intensive danger areas: 1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies. As I said, the guy’s worth paying attention to.