Monday, May 21, 2007

An incredibly significant event for the equity markets

Yesterday there were announcements of acquisitions with values of $27.5 billion for Alltel and $37 billion for two Italian financial services companies. The biggest number, however, was a $3 billion investment. That is China's new State Investment Company's agreed upon investment in Blackstone Group, the U.S. private equity giant that is planning an IPO for later in the year.

With over $1.2 trillion in foreign exchange reserves to be invested, China to date has limited itself to reinvesting in China and investing in the debt securities of other governments. Now China is liberalizing its rules to allow its Central Bank and its investment arms, as well as major financial services institutions, to diversify investments to equities in other countries. This allocation to equities could both improve their returns on their reserves and extend China's economic clout in a meaningful way.

The model for China is the Government of Singapore Investment Corp., or GIC. GIC has for the last two decades been a significant player in global equity markets and a major client of the largest U.S. investment banks. They participate with research and investment acumen that rivals any major U.S. asset management company and have meaningful investment returns.

The U.S. equity market has more depth and greater transparency than any other equity market in the world. While the market has been on what seems at times to be an almost implausible bull run over the last several years, P/E ratios are still reasonable, especially compared to a market like China(of course). The U.S. currency is a bargain. So the table is set. China's initial foray is a passive private equity investment into non-voting shares of Blackstone, but the potential for capital flows into U.S. equities is huge.

We look at the fixed income yield curve and for more than two years have seen an inversion that allows money market investments or short term CD's to yield more than a 10 year treasury. Economic growth continues at a modest pace and the forward predictive power of the fixed income market seems to be in question as a result of the demand for fixed income securities by China and other global export driven emerging economies. Could the same phenomenon now come to the equity markets. Could a U.S. centric approach to equity valuation be trumped by inflows that measure value with different metrics. In other words, is it possible that the next step in the equity markets is a huge rise driven by a new source of investment. Could the U.S. equity market become a mirror image of the U.S. fixed income market and defy traditional analysis.

The widening of China's investment approach will not happen overnight, but once it gets started and its new China State Investment Authority is fully functional it will likely evolve more rapidly than anyone will predict. All things being equal, meaning no geo-political disaster, no serious U.S. consumer meltdown, and no dysfunctional capital markets event, the impact of China's investment change will be material.

This may be the most important equity market news of 2007.


Anonymous Eddie K. said...

You're probably right. The eventual impact of Chinese capital flows into equities may be meaningful. But is this setting us up for a double whammy. You mention yourself in your 4/24 post the voting machine/scale analogy about the stock market. When the markets, fixed income and equities, eventually must step up to that scale, oh my god, all the tea in China won't save us.

10:58 PM  

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