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"Cash Is King These Days"


Equity markets are plunging. Corporate bonds are sagging. And as panicky investors rush for the exits, they are unleashing a wave of cash. Almost $800 billion has been generated worldwide by dumping stocks over the past quarter, calculate market experts. Some of that is being reinvested in government bonds, real estate, or hedge funds. But the largest single chunk--some $275 billion--has gone into cash deposits around the world. "Cash is king right now," says David Jeal, marketing manager at the Share Center, a British retail stockbroker.

Ordinary investors cannot think of anything safer than cash. But such prudence could vastly complicate life for economic and monetary policymakers. Because those billions are not being channeled back into productive investments, it could spell bad news for the economy. "We foresee trouble ahead," says Stephen King, head of economics at HSBC Investment Bank in London.

Worried by accounting scandals, corporate bankruptcies, telecom company woes, and the possibility of a further decline in equity prices, investors just about everywhere are cutting their losses and bailing out of equities. And we're not just talking about individuals who have invested in their domestic markets. The recent, unexpectedly large decline of the dollar--which has fallen 12% against the euro so far this year--and the prospect of more currency market volatility to come has shocked many insurance companies, pension funds, and other institutional investors into selling off at least part of their overseas portfolios and bringing their money back home. Europeans pulled about $58 billion from U.S. markets in the second quarter. Only the Japanese have stayed largely committed to the U.S. They're keeping their money in U.S. Treasuries.

Just as European institutions are repatriating investments from the U.S., so U.S. institutions are repatriating money from the euro zone, where stocks have been hammered, too. Some $100 billion or more has been brought back home by international investors of all stripes in the past three months. "In times like this, investors feel more secure in the markets they know best," says Lukas Daalder, head of research at Oyens & Van Eeghen, a brokerage in Amsterdam. Of course, the money's not going back to the stock market, which spooks the central bankers. "There has never been a period when a bear market coincided with an economic upswing," says one Deutsche Bundesbank official. "It makes the decision to raise or hold rates much harder."

As the uncertainty mounts, some institutions have concluded that they can't expect to make the 15%-plus returns from stocks that they made during the bull market of the 1990s, so they're paring their equity holdings. Take British insurance companies, which have typically channeled up to 70% of their investments into shares. Most are selling off at least some of them and moving the money into other assets--including bonds and cash--where they think it will be safer. Even Continental insurers, which on average invest just 30% of their portfolios in equities, are selling shares in the face of tumbling markets. Analysts say bigger sales are likely on the way as underwriters struggle to maintain solvency ratios. "A major rebalancing is taking place," says Richard Reid, chief equity market economist at Schroder Salomon Smith Barney in London.

If the money being freed by the great stock sell-off went into other classes of equities or corporate bonds, it wouldn't be a big deal for the global economy. But it isn't. "There is a lot of money out there, but it isn't being invested," laments Claude Bebear, founder and chairman of French insurance giant Axa.

In this environment, people are waiting for proof that the market has bottomed before moving back into equities. The big fear: that the markets may plunge an additional 30% or more before they turn the corner. In Europe, investors are not even tempted into corporate bonds because they don't trust the creditworthiness of many of the companies that issue them. "Fear and stress are at extremes in all financial markets," says William Cunningham, director of credit strategy at J.P. Morgan Chase & Co. in New York. "Nearly all traditional valuation tools show corporate bonds to be very attractive, but spreads continue to widen."

The trouble with these huge cash balances is that investors could eventually either do something dumb with them or do nothing at all. First, the dumb stuff: There has been a noticeable uptick in the volume of cash flowing into property--some $200 billion globally. That has helped fuel the recent boom in house prices, especially in Britain and the U.S. House prices in the East Anglia region of Britain have risen 20% in the last 12 months. On balance, that's bad news for the global economy. The property boom, especially in Britain, is beginning to look like a speculative bubble of its own that could soon burst, giving many investors as big a shock as the equity collapse.

Meanwhile, other gobs of cash are rolling into hedge funds--even in Europe, which has seen a marked growth in hedge activity. Worldwide some $29 billion flowed into hedge funds in the last quarter. Since even hedge funds struggle to make decent returns in this market, they are driven further into risky new investments, such as arbitraging the statistical differences between one convertible bond and another. Hedge fund strategists argue they perform a valuable function by ironing out inefficiencies in the market. But some market gurus say they increase volatility by diving into hazardous plays and unsettling traditional investors. Either way, it's hard to see how their activities benefit the economy as a whole.

The biggest worry is that the huge amounts of money held in cash aren't being used productively. About half of the cash pile globally is going into money market or highly liquid funds. If actively managed, these funds can earn up to 4% from certificates of deposit and short-term treasuries. The other half is stuck in bank deposits, whose returns are often less than 2%. Judging by central bank statistics, little of this cash is finding its way into increased bank lending. In Germany, for instance, lending to the corporate sector has hardly increased at all over the past six months, causing some business folk to worry a credit crunch is on the way. Faced with a rising tide of insolvencies, banks are actually cutting back their lending to small and medium-sized companies. Cash may be king for investors, but hundreds of billions of dormant dollars and euros are the last thing the global economy needs right now. By David Fairlamb in Frankfurt


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