A Year in Review, 2006

2006 has certainly not failed to impress. We have had a number of huge shocks, and we leave this year with the biggest of them all, a severe fall in the value of the dollar against the other major currencies. I must admit that I was one of the very few people who did not anticipate this, despite many suggestions to the contrary. However, my thinking was, and continues to be, based on the premise that the justifications presented to explain why the dollar would fall are no different to the one’s suggested in the past, which in most cases had not proven to be correct.

However, similar to the War in Iraq, we are where we are and we have to see how the fall could impact the U.S. economy, and the signs are not good. If the dollar falls so much that the U.S.’s two big creditors, China and Japan, are happy to cut their losses and run then the cost of borrowing in the U.S. would rise significantly and push the economy, which is already showing signs of fragility, towards recession; perhaps even a severe one. 2007 could prove to be a pivotal year for the U.S. and its currency, and have far reaching implications, as it could be the year that China and Japan, and perhaps India, might decide to diversify their substantial holdings of the dollar.

This year also provided further evidence that most hedge funds should be viewed more in terms of an asset class that acts as an insurance against bear markets than necessarily a guaranteed way of outperforming the markets, since they seem to perform significantly better when times are bad than when the markets are bullish. Of course, there are exceptions to this rule, but then again we also find some traditional managers that continuously beat the markets. Having said that, the true diversification benefits of using hedge funds within a global asset allocation process has yet to been fully utilized, and there are signs that many traditional asset managers are recognizing the short-comings of most funds of hedge funds in fully realizing the alpha diversification benefits of hedge funds and trying to take advantage of this fact themselves.

Another member of the world of alternatives, private equity firms, proved that they are able to takeover even bigger firms than they had in the past and it seems that in the not so distant future most of the world’s largest acquisitive transactions will be conducted by these types of institutions. CEOs of major companies based within the Anglo-American economies have always been living in the fear of becoming a takeover target, but now with this new breed of acquisitors on the scene their worlds seem that much more worrisome.

Sadly, as of December 2006 there are still many countries in Europe that feel that while it is ok for their national champions to take over peers in other markets, these same companies should be protected from being taken over by companies based within the other member states. The way that France, Italy, and Spain have reacted to take over attempts by companies based in other member states proves that as yet they view the Union as an institution in which there are some rules for those who wish to play by the rules and then other rules for those who view themselves as more special than the rest. The issue is, of course, that sooner or later these barriers will be force down. And when they do come down, no matter how big the national champions have become they cannot be too large for the private equity firms that are now taking over most of Europe. So, taking over peers in other markets will not in any way mitigate the risk of becoming a takeover target once the barriers are forced down.

The property market corrections have already started in the U.S., and the U.K. seems ripe for a severe correction as well. Using our own unique methodology we found that first time buyers are for the first time worse off than they were in 1989, the year before the previous property market crash. I, therefore, anticipate a severe correction in the U.K. property market in not so distant future, something my learned colleague and the author of many studies on the European property market, Keith MacDonald, does not agree with. Of course, only time will tell.

Finally, on a more positive note, the fears caused by the sudden and extremely worrying rise in the price of oil have now dissipated and we seem to be moving towards more realistic and acceptable levels. However, there is the risk that as the price of oil falls, the urgency for finding alternative sources of energy might dissipate, something our small planet can ill afford.

Given that this is the last bulletin of 2006, we would like to take this opportunity to wish you all a wonderful Christmas and a more successful and prosperous New Year.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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