Why are investors so complacent?

My last piece on September 2nd was on investor complacency. I expand on the theme here. In these two weeks, the Mumbai Sensex index has barely moved. With the summer months behind them, investors have to reassess the outlook for the last four months of the year. Usually, they are more eventful.

Three unrelated articles carried by Financial Times on Wednesday made interesting reading. One was on page 15. It was by John Authers and was called the ?short view?. It looked at the recent surge in investment flows into central and eastern Europe. Hedge funds dedicated to the region have surged more than 20% this year, whereas the IMF warns that the region has many countries with rising current account deficits and that the ratio of private sector credit to gross domestic product has risen in the Baltics, Bulgaria and Slovenia. The author concluded that the region feels like Asia did in 1996.

On page 20, there is an article on the demand for ?Payment in Kind? (PIK) notes issued by companies owned by private equity funds from hedge funds. These bonds are risky and would be impossible to recover any money in the event of default. Yet, these notes are hot.

Then, there is one more news item on page 25, which talks of Moody?s announcement due on a formal system that it was creating to assess the strength of investor covenants attached to corporate bonds in both the US and Europe for the first time. Concerns are growing that investors might be vulnerable to unexpected losses on their bond holdings. These concerns have been triggered, in part, by ultra-benign credit conditions in Europe and in the US.

Indeed, there are other indicators such as the strength of the Indian stock market and that of the extreme tightness in Emerging market bond spread that suggest extreme level of investor comfort with prospects for returns in developing countries. Taken together, these items convey a level of investor complacency that it not captured by ?euphoria-pa-nic? and investor sentiment indicators that suggest caution.

I would also recommend that re-aders read the article by Martin Wolf on page 13 (FT Asian edition, September 13, 2006) on the fin-ancials of the IMF. IMF financials are deteriorating bec-ause emerging ec-onomies are doing well! No one is going to them for structural adjustment programmes after Argentina did in the early part of this decade. Hence, the income if the IMF is falling.

Emerging nations have decided that they would accumulate current account surpluses. On top of that, they also began to attract capital which they then on-lend to the US government. US treasury yields end up being lower than they would otherwise be. American consumer spends and imports from Asia. Their exports rise and current account surpluses keep rising. It doesn?t seem to be a world of imbalances but a world of perfect arrangement.

Yet, it could go wrong if private capital flows to emerging markets dry up. Why would private capital flows dry up? They would only if their expectations of returns changes. That could happen if there is any perceived or real crisis in any of the countries that are currently flirting with slippages as highlighted earlier.

Alternatively, it could also be due to any real or perceived policy slippage such as the one featured in the front page of the Financial Times today on Indo-nesian labour ref-orm. The govern- ment in Indonesia, under pressure fr-om labour unions, has dropped its proposal to ease the labour market.

Or, the attractiveness of emerging markets could change if growth stays robust in the US and the market revises its current benign interest rate expectations. The decline in the price of gasoline and the decline in bond yields could boost consumer spending and keep the US economy humming. Applications for new mortgages have increased for the second straight week in the US. If the US economy grows at or slightly above potential, then inflation expectations would not decline. The Federal Reserve would be back in the game.

The 90-day dollar interest rate future has dropped three basis points since the beginning of the month. So, the market has increased its estimate of the 90-day USD interest rate from 5.345% to 5.375%. It is not much but it is significant given that, during this period, there has been fervent speculation on the US housing slow-down causing a recession and yet, interest rate futures have moved in the opposite direction.

Barton Biggs, former CEO of the Asset Management division in Morgan Stanley and now a founding co-partner of a hedge fund Traxis, in his book Hedgehogging, feels that the next bubble, after the last one in technology stocks at the turn of the millennium, could be in emerging market assets. Christopher Wood of Credit Lyonnais Security Asia has a long-term target of 40,000 for the Mumbai Sensex Index. Of course, he leaves the time horizon undefined. Even if these gentlemen were to be proven right eventually, the path from here to there would hardly be a straight line. After the spectacular, three-year bull-run in emerging market assets, it certainly feels that the time is ripe for some basic lessons in investing to be relearnt.

?The writer is head of research, Asia-Pacific & Middle East, Bank Julius Baer, Singapore. These are his per- sonal views. He can be contacted at jeevatma@gmail.com