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Following the money

Observing foreign investment in a market is like taking the temperature of the industry. It''s a way of measuring the areas that are projected to suffer, and those expected to be strong.

When assessing the future health of a domestic market or potential opportunities abroad, processors might want to take into account major trends in the flow of foreign investment. Foreign investment can help develop emerging markets by providing capital for growth, but as investment expands in one area, it often contracts in another.

Much of the foreign investment made today is of the short-term variety, and as such can fluctuate dramatically from quarter to quarter or from year to year. Longer and more significant migrations of capital can signal important market trends.

Today''s perspective

For several years, investment increasingly has been funneled into emerging markets, and the falling dollar has made other mature markets attractive to investors. In 2004, when measured in dollars, Frankfurt''s Xetra Dax jumped 16% and the Paris CAC 40 Index rose 15.7%, while emerging markets expanded by 22%.

The United Nations Conference on Trade and Development (UNCTAD) reports that total foreign direct investment (FDI) inflows for 2004 rose by 6% to $612 billion, but that FDI flows into developed markets continued to shrink. It''s now estimated that developing markets account for a record 42% of the world''s FDI inflows, up from 2001-2003 highs of only 27%.

The once stable dollar market has also begun to take a beating as investors start to look for a more secure currency for their reserves. One increasingly troubling, although not yet alarming, example of this reallocation is OPEC, which has reduced the amount of reserves it holds in U.S. dollars from 75% in Q3 2001 to around 61.5% by the end of 2004.

The cause...

Before we talk about the effects of this reallocation of funds, let''s take a moment to look at the reasons behind the shift.

  • The falling dollar is no doubt one of the biggest reasons for the increased interest in foreign markets. For U.S. investors, as the dollar lost value in 2004, returns on their foreign investments received an additional boost when they were converted back into dollars.

  • For foreign investors looking to park their reserves in a monetarily secure market, the plummeting dollar has made the more stable euro an increasingly attractive option.

  • The search for double-digit returns is another motivating factor for investment in developing markets. Investors still high on the hefty profits of the 1990s are finding thinner margins in a more mature U.S. market; they are attracted by cheaper foreign stocks that have higher growth potential.

  • The generally higher yield on foreign stocks has also helped propel this trend. The December issue of Institutional Investor International pointed out that while the average yield for the Standard & Poor''s 500 index is 1.7%, the FTSE all-share index yields 3.17%, a characteristic also common to other European and Australian indexes.

  • Regional concerns have likewise helped redirect investment flows. For example, Middle East investors have expressed concerns that their U.S. assets could be frozen if the government suspects any connections to alleged terrorist groups or individuals.

    ...and effect

    Expect to see investors continue to diversify their dollar holdings as huge trade and budget imbalances persist in tarnishing the greenback''s stature in 2005 and 2006. This diversification will mostly likely be toward the euro, a definite boon for the EU economy as long-term investments in currencies can act like a loan that never needs to be repaid.

    That said, U.S. processors shouldn''t worry about the dollar completely tanking-at least not soon. The monetary policies of Asian economies like China, Japan, Malaysia, and others have left these nations holding enormous concentrations of U.S. dollars. Consequently they will be reluctant to allow the value of their investment to fall significantly and will continue to purchase bonds.

    Private investment is another story entirely. Private investors will almost certainly continue to diversify their holdings into more stable currencies like the euro. This will be a welcomed benefit for European companies looking for capital investment.

    To counter the negative effects of these influences, processors can bank on the U.S. Fed to continue to raise U.S. interest rates. As the amount the U.S. government pays its investors rises, the U.S. market should win back some of these diverted investments. However, the fear here is that significantly higher interest rates might slow the U.S. economy.

    The ability of developing economies to attract new FDI might also be challenged by a slowing global market in 2005. Although growth is not expected to fall significantly, for developing markets that are heavily dependent on the exportation of commodities, any diminished growth could scare investors. Markets such as Brazil and other Latin American nations might see their share of FDI shrink in 2005 and 2006.

    Markets that export commodities like oil and natural gas should continue to receive significant FDI. We expect energy prices to cool but supply to remain tight in 2005, despite a somewhat slower pace of global growth and a possible cool-down in several sectors of China''s economy during the second half of 2005.

    The bottom line

    While market forces will both push and pull investment to and from the U.S., processors can be fairly confident that:

  • The Fed will to continue to raise interest rates in 2005. If the trade deficit accelerates in the first part of 2005, expect increases of a half point or more.

  • While the euro will continue to represent a greater share of the world''s governmental and private reserves (especially among the EU''s primary trading partners like Russia and OPEC), the dollar will remain the preeminent currency.

  • Despite losing some steam in 2005, structural problems in the developed markets of the U.S., Europe, and Japan should ensure that the developing markets continue to capture a larger share of the world''s FDI.

    Market highlights

    China On the heels of a likely boon for the textile sector, the Chinese National Bureau of Statistics released a report in late January that showed that the nation''s GDP grew by a year-on-year rate of 9.5%; a jump from the third-quarter rate of 9.1%, despite efforts by the government of China (GOC) to curb growth.

    According to a December report in the China Chemical Reporter, the GOC will launch an "oil price reform scheme" intended to allow a more market-driven mechanism to control oil imports, wholesaling, and retail sales. The program is intended to complement recent liberalization of the retail market for oil products.

    This liberalization of the energy market will have significant implications for Chinese manufacturers, especially during periods of high prices. If open energy markets bring higher consumer prices for energy commodities like natural gas and crude oil, consumption levels may fall, easing pressures on global supplies.

    India China isn''t the only developing nation grabbing investors'' attention of investors; the major investment house Lehman Bros. is establishing an investment fund dedicated exclusively to India. The country''s industries should also benefit from a planned global fund that will be dedicated collectively to the emerging markets of India, Brazil, Russia, and China, which is reportedly in the works at Goldman Sachs.

    Moves like this should add fuel to India''s already climbing global investments. India''s foreign investment income in 2004 hit record highs, receiving nearly $100 million daily.

    Latin America After recording an impressive growth rate of 5.5% in 2004, growth is expected to remain strong in 2005, but closer to 4%. What makes this period of growth different from expansions is that GDP growth this time is accompanied by a rising surplus in the balance-of-payments.

    Eastern & Central Europe The UNCTAD''s World Investment Report 2004: The Shift Towards Services, predicts that with the recent accession of the EU''s 10 new members, Europe is primed for a "second wind" of foreign investment.

    Western Europe Many of Western Europe''s economic powerhouses like France and Germany continue to struggle to make the difficult changes to their social welfare systems demanded of them by the Lisbon Strategy and the EU Growth and Stability Pact. Despite a general understanding among EU leaders for the need to reform these uncompetitive social welfare programs, resistance from trade unions and the general public remains high, as was apparent during the transportation and service strikes in January.

    The U.S. Just when you thought the party was coming to an end, housing starts again expanded in 2004, growing by 5.7% to 1.953 million. New housing permits rose 6.8% for the year, ending at 2.018 million units.

    Production levels for U.S. factories, mines, and utilities rose by 4.1% in 2004, making that span the best annual showing in four years. The U.S. wood-plastic composite market is again expected to show impressive growth in 2005.

    Agostino von Hassell [email protected], and Mark Bella [email protected], of the Repton Group LLC (New York).

  • TAGS: Business
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