Special Financial Interest: Islamic and Ethical
(Abstracted From Emirates Investor)
President Obama’s Short Honeymoon
Abstracted from Asian Tigers Investor Report, Hong Kong, January 2009
Well, we’ve done the easy part now. President Barack Obama has made it to the White House with the cheers of the world still ringing in his ears. The first black president in America’s history has made an impressive start, assembling a rainbow government of right-wingers, left-wingers, independent thinkers and economic experts, who between them represent the most competent team the country has seen for many decades. And, as his first 100-day term gets under way, everybody in America wants to be a part of the Obama wave. At times like these, it’s easy to be popular.
But now Mr Obama needs to make urgent choices about the U.S. economy - and that means that he’ll soon be making enemies too. The new President has inherited an economy that’s veering into recession, and a budget deficit that’s forecast to hit $700 billion (6% of GDP) in fiscal 2009. Plus a trade deficit of around $850 billion in 2008, of which getting on for $300 billion was with China alone. Meanwhile, with unemployment up to 7.2% and factory output down by 7.8%, the US voters who are currently giving Obama a 79% approval rating will soon start demanding that he must protect their jobs at all costs. That will probably mean tough talking on trade with the Far East. Anything else will likely mean that his enemies are in his own back yard instead.
Admittedly, being more popular than George W Bush wasn’t ever going to be too difficult. Dubya was lazy, closed-minded and (in the words of his aides) “strangely incurious” about just about everything. His basic assumption was that America was the world’s unchallenged superpower - despite clear signs that challenges were already springing up in Europe, in China and in many other places - and he assumed that, if other countries failed to accept America’s “natural” dominance, it would be safe to ignore them or simply to overrule them. Indeed, it was as if Dubya felt that Washington’s sheer military power was enough to underwrite that assumption. Although fortunately he never expressed it in exactly those words….
President Obama is made of different stuff. His first significant foreign policy move was to question Israel’s right to dominate its Middle Eastern neighbourhood with overwhelming military force. By bringing forward the withdrawal from Iraq and by closing down America’s notorious interrogation centre at Guantanamo Bay, the new President has shown himself willing to consider international opinion in a way that his Republican predecessor would have found shocking. Obama’s early speeches have stressed that America needs to soften its line and learn to negotiate, not dominate. This is all encouraging stuff.
Yet, for all George Bush’s presidential failings, we should recognise that he was a fairly strong advocate of free trade. Although Dubya was not shy about subsidising America’s farmers, he generally resisted the pressures from his own side to stamp down heavily on imports from Asia. Instead, it was the back-benchers from Mr Obama’s own party, the Democrats, who favoured protectionist policies.
Back in 2005, it was the New York Democrat Senator Charles Shumer who passed a bill threatening China with punitive trade sanctions unless it abandoned its ‘weak renminbi’ policy, which he said had cost three million American jobs. It’s the Democrats who are now demanding special protection for the US car industry, and it’s the Democrats who have set up the huge bank bailout plans that will soon force President Obama to issue vast quantities of new debt - much of which, ironically, will be targeted at Asian central banks….
There’s more. Obama’s new Treasury Secretary (Finance Minister) Timothy Geithner accused China only the other week of “manipulating” its currency - a strong choice of words which elicited an indignant rebuke from Beijing. Foreign Secretary Hillary Clinton added, rather condescendingly, that China’s economic relationship with America was “not a one-way effort” but would require “negotiation” instead. It is, perhaps, notable that Prime Minister Wen Jiabao’s official schedule during his recent visit to Europe did not include meetings with any Americans - or that President Obama’s first official visit to Asia is scheduled for Indonesia (where he spent part of his childhood), and not China.
In short, this is not shaping up to be an easy relationship. Businesslike, certainly. Blunt, probably. And all of it underpinned by the awareness that Asia’s hurtling economic growth is in stark contrast to a Western world which has fallen on hard times. There is goodwill here, and mutual economic need. But President Obama will not be any kind of pushover.
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Borrowing and Insanity
Abstracted from Investment International
'Be not a man who strikes hands in a pledge. For, if you should lack the means to pay, your very bed will be snatched from under you....' (Proverbs 22: 26-27).
Ah, it was so easy to be straightforward about these things back in the good old days when there were no such things as overdrafts, no fixed-rate loans, no zero-rate credit card offers, and above all no stock markets to tempt us away from the straight and narrow.
But, unfortunately, the truth is that things have got a bit more complicated since the sages of ancient Israel first put these sacred thoughts down on vellum, and these days we often have little option but to ignore them. Refuse to carry a credit card because it puts you in a state of debt, and you're likely to become a laughing stock – not to mention a nuisance at the supermarket check-out. Refuse to start an investment programme in your early life because you're young and you already have a mountain of other debts, and you'll be accused of neglecting your future needs, especially your pension. We're so accustomed to borrowing money that it seems almost obstinate of us to refuse it.
Yet it still feels like a big step when we first decide to borrow a sum of money for the sole purpose of investing it in the stock market. It feels risky, it feels invigorating, it feels slightly wicked. (As some people believe it genuinely is.) And growing numbers of people are doing it. Indeed, considering how fast the global stock markets have grown (until recently, anyway), to do anything else would have seemed like a criminal waste of an opportunity.
Besides, let's get one thing straight. The laws of both history and probability are indisputably on your side whenever you borrow to invest. Any long-term study of the financial markets will confirm that the capital returns from a stock portfolio outstrip the real cost of borrowing by five to ten per cent a year, and often more. If you borrow $10,000 at 8% in order to double the $10,000 investment that you can actually afford, and if your $20,000 investment achieves a capital growth of 25% this year, then you'll end up with $14,200 ($20,000 x 1.25, minus $800 in interest on the borrowed $10,000, minus the $10,000 that you still owe to the lender), rather than the $12,500 that you'd have had if you'd paid for everything in cash. The so-called gearing process has increased your profits by 68%, from $2,500 to $4,200. And all you did was ask for the money.
But first, a quiet word of caution. A good friend of mine was forced to confess to his wife, some years ago, that his gamble on the futures markets had gone disastrously wrong and that the bailiffs would shortly be arriving to repossess the family home. She is, of course, now his ex-wife. And the fact that my friend was a financial adviser by profession didn't make things any easier. So can we please make a plea to our readers to take the risks seriously, and to weigh up every decision as if your marriage depended on it? Because you never know, it might.
The American Way
We probably ought to start with the most modern form of the practice and take it from there, because there's little doubt that the North American model for borrowing-to-invest will soon be available to a much wider investing public. US and Canadian investors have become very keen on a sort of half-and-half system known as margin investing, in which they literally borrow up to half of the money they need for their investments directly from their brokers. Or to be precise, their brokers advance them the money (the "trading reserve") while using their existing cash and stocks as collateral. There is of course an interest rate to be paid as well (around 7% in the US or 8.5% in the UK), but that won't usually worry an investor who'll have his eye on the much larger gains that the stock market can normally provide.
There are terms and conditions, naturally. A broker won't normally be interested in accepting as collateral any stocks which you hold under somebody else's control (such as certain types of investment trusts), and he may also be picky about which stocks he'll let you hold on margin. Charles Schwab, perhaps the biggest margin lender in the US, currently frowns on about 250 US stocks – compared with just 25 on the restricted list a couple of years ago.
The broker will demand the right to sell your holdingswithout your permission if he thinks that things are getting too risky. Or alternatively he can make a margin call, in which he demands that you repay some of the debt if the net value of your stocks should ever sink too low. American law forbids him from letting you have more than half your investment on margin at any one time, so you mustn't take these things personally.
How big is the margin investing business? The figures are huge, the percentages are small. Merrill Lynch, another of America's largest margin lenders, said last year that it had advanced $23 bn of outstanding margin debt, much of it to small investors who had cashed in on the technology boom. But Merrill Lynch was also quick to point out that this is just a tiny sum compared with the $1.5 trillion worth of global assets that it maintains on behalf of its clients. Bear Stearns & Co confirms that the overall level (about 1.5% of total stock market value) has stayed constant for the last few years. In real money, that represents about $250 bn of US margin debt.
Margin investing isn't a new phenomenon, but you have to go back to 1929 to realise quite why the authorities are so cagey about letting the practice grow out of control. Shortly before the Wall Street crash it was estimated that as much as 30% of the total US stock market was invested on margin, and when things went belly-up it was the banks and the lenders rather than the punters who lost so much of their essential liquidity. More recently, the Hong Kong meltdown of 1987 was caused almost entirely by margin investing of a different sort – this time, the local addiction to options trading – but the general effect was the same, a terrible hit on the liquidity of major lenders which lasted for weeks. So the Federal Reserve Bank stoutly maintains that any growth of margin investing is a thoroughly unhealthy sign that things are getting too frothy.
You'll have noticed, of course, that the technology boom is no longer what it was, and so you won't be surprised to hear that America's enthusiasm for margin investing has diminished somewhat over the last twelve months. The brokers are certainly feeling the pinch: TD Waterhouse specifically cited the sharp drop in margin investing as a reason when it fired hundreds of staff recently. But the lawyers are doing rather better out of this changed situation, because furious US investors have taken to suing their brokers in large numbers for making wrong margin calls, for selling off the wrong investments, for selling them at the wrong moment, and - yes, you guessed it - for being so foolish as to lend the foolish punters their money in the first place.
The Australian Method
Aussies don't have such easy access to American-style margin trading techniques at the moment, so the favoured down-under method at the moment is to take out a bigger mortgage in order to start yourself off on the road to riches. Rising property prices have boosted the feelgood or feel-wealthy factor to the point where it seems simply logical for many couples to start their investment programmes at the earliest stage.
But as many advisers are quick to point out, you do need to feel completely confident that the value of your home isn't going to fall dramatically while you're out there making your fortune, because it represents the collateral on which your entire trading position rests. And you can expect trouble from your mortgage bank if the value of your loan is anywhere near the full current value of your home, because the bank will worry that a sudden plunge in the housing market could leave its loan completely under water at any time.
You also need to be aware, like any other bank loan borrower, that an unexpected rise in the lending rate could inflict a painful double whammy on you if the conditions were right/wrong. Not only would the rate rise make it more expensive for you to service your debts; it would also have a dampening effect on the stock market - thus thwarting your intentions in no uncertain fashion and possibly leaving you badly exposed. Approach with care.
The Bank Route
Taking out a bank loan has long been the favoured way of starting up an investment portfolio for those investors who don't have the time or the patience to seek out cheaper alternatives. Many a day trader has started on his way to what might be immense riches using a quick cash advance from a credit card (aren't those cut-price introductory deals tempting?), or perhaps by taking out a $25,000 unsecured loan from a high street bank. The larger the advance, the cheaper the terms. But you do need to accept that you'll always be called to account even on an unsecured loan if things do go wrong – there's no walking away, unless you really want a criminal record hanging around your neck.
Things get more difficult if you're after larger amounts of money. You'd need to be pretty good to convince your usual bank manager that he ought to lend you $100,000 so that you could start your own portfolio – at the very least, he'd want to see a very impressive track record from you, not to mention a few qualifications – so some people who go down this route foolishly decide to use some degree of stealth. They buy a boat on credit, they sell it, and they invest the proceeds. We're not for one moment recommending this sort of practice, because it's as fraudulent as it is risky. Surely it's better by far to be honest with yourself, and with others? Sell your life assurance policies to raise the cash if you have to, because at least you'll be facing up to the realities of the situation you're getting into.
Sensible Defensive Measures
Do try to build in some defensive measures at the earliest opportunity. Unless the market is both wildly optimistic and consistently so (which is a much less common state of affairs), be prepared to sacrifice some of your future growth potential for the sake of paying off at least a little of your debts, and make it a rule to set aside a fixed proportion of every profit you turn for this purpose.
Set a stop-loss target every time that your shares rise, and have the courage to stick to it. Say to yourself: "I'm not prepared to tolerate a loss of more than 25% on this stock, so if its price drops by a quarter from today's level I'm going to sell it." The point about a stop-loss is that it removes that all-important question of ego from your thinking.
Never, never get into margin trading with borrowed money – and especially not into futures, where if things go wrong you might end up losing multiples of a cash stake that you never really had in the first place. My bankrupt friend's wife wishes somebody had given him that advice many years ago.
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Interest Rates and the Wimbledon Syndrome
….Now, there are times when it’s a good idea to raise bank rates, and there are other times when it isn’t. If you’re running a country where inflation is starting to get worrying – usually because the consumers are buying more stuff than is really good for them – then increasing the base rate makes good sense. It makes them stop and think before they go out and buy another car, and it can be a really good way to head off the likelihood of soaring inflation. In fact, it’s one of the great pities about the euro, the single European currency, that the euro club’s national governments don’t have the power to raise their own rates any more. (Only the European Central Bank can do that. Which is rather hard luck on inflation-prone Ireland).
But there are other times when you just know that it isn’t going to do a damn bit of good to raise the bank rates. And, as far as Europe and America are concerned, this is one of those times.
Why’s that? Well, try thinking of it this in tennis terms…...
Imagine you’re sitting in the audience on the Centre Court at Wimbledon. The sun’s shining, the strawberries are delicious, the atmosphere’s fantastic, and everybody’s nice and comfortable. But you suddenly decide that you’re entitled to a better view of the tennis. So you get up out of your seat and stand up instead.
Well, it won’t be very long before the woman behind you stands up as well – because that’s the only way she can see the match, now that you’re in the way!
And so does the man behind her. And the man behind him. And the woman behind all of them……
The next thing you know, everyone in the stadium is standing up. Suddenly nobody’s comfortable any more. And – more to the point – nobody’s any better off!
That’s pretty much the way it goes with interest rates these days. The United States is faced with the problem of a falling dollar, because frankly that’s what it will take to put its economy back in shape again. You can’t just keep on borrowing that much money indefinitely without experiencing some loss to your national credibility. But instead, America’s financial leaders have decided that, rather than stomach the drop in its dollar, they’ll raise U.S. bank rates.
Now, higher interest rates are the surest way to put a pit-prop under a failing currency and restore the status quo, because they make dollar investments a bit more attractive to foreign investors. And sure enough, the rate rises – seventeen of them since June 2004 - have been working well enough for the last couple of years now.
But what happens if other countries start to feel aggrieved about the way that the dollar’s rise is sucking all the liquidity out of their own markets? That’s pretty much what Europe’s been feeling for some time now. And so it came about that, earlier this month, the European Central Bank flagged up a half-point rise in the euro zone’s bank rates. Predictably, the euro strengthened.
But, equally predictably, all the oomph went out of the dollar and it started to sag again. So, sure enough, it wasn’t long before the Federal Reserve Bank started to make noises about how more bank rate rises were in the offing. And the dollar was off again.
And that was when Japan started to muscle in on the argument with its own rate rises. True, they haven’t been formally introduced yet – they’ve only been hinted at. But in the last week the yen has soared massively, as the markets have got wind of this development. And that in turn has weakened the dollar….and the euro…..and the pound…..
None of these countries really needed to raise bank rates because of inflationary fears. America’s consumer price rises are running at 4.2% - or about the same rate as Spain. The euro zone’s average inflation is only 2.5%, and Japan’s is only 0.4%. In fact, all that’s going to result from these bank rate rises is a slower rate of growth for all their economies. And, as stock market investors, that’s something we need like a hole in the head right now.
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Islamic and Ethical Investment
………What is an ethical company? There are three basic methods for deciding which companies should be in your portfolio - positive selection, positive avoidance (also called "negative selection") and finally the so-called "engagement" policy. The engagement method is predominant in North America, but oddly enough it's hardly known at all in Europe, where the first two methods are normally used.
Positive selection is when you (or your fund) make an active decision to invest in companies that make an active contribution to the principles that you hold dear – normally including such ideals as environmental protection, pollution control, conservation and recycling, or safety and security. Certain investors, and their funds, will add specific criteria of their own – for instance, they may favour companies that work for certain political or religious causes. As we'll see shortly, an Islamic ethical fund will normally insist that any banks within its portfolio adhere to Shari'ah rules.
Positive avoidance is an easier concept to define. Ethical investors who favour this technique will avoid buying any company that engages in certain types of activity – typically arms and nuclear weapons, animal exploitation or experimentation, alcohol, tobacco, gambling, pornography and anything that damages the environment. For some Western investors, pharmaceuticals, genetically modified crops and nuclear power are considered to be uninvestable, and there are many vegetarian investors who will reject anything at all to do with the meat, fish or leather trade. An Islamic ethical fund would reject anything to do with alcohol, tobacco, pornography, violence or pigmeat products.
Many mutual funds will add their own exclusion clauses which prohibit contacts with certain national regimes And even non-Islamic ethical funds will sometimes have nothing to do with major international banks, which they may accuse of milking the developing world for profit.
The "engagement" approach ,also called an "influencing" approach, takes a much more liberal line on the activities pursued by its chosen companies, and it places a heavy emphasis on backing companies which treat their employees well – for instance, by having democratic decision-making structures in the workplace, or by making sure that their workers' partners and spouses are properly treated. The manager running an engagement fund will set up a dialogue with his chosen companies which will allow him to monitor how well they measure up against his own particular set of criteria. If he's satisfied enough to include them in his portfolio, then the company can expect its stock price to go up as a result of the higher demand from his clients; but if the company fails to measure up he'll be able to exact a heavy penalty when he removes it from the list.
European investors complain, rightly, that sometimes US-based "engagement" managers don't apply any of the other usual ethical criteria to their selection process, and they say that all kinds of companies can slip through the net as a result. An arms manufacturer, a GM foods developer or a nuclear power facility can sometimes achieve ethical fund status under these criteria. Domini 400, which is probably the most influential US ethical fund index, has included such companies as American Express, Boeing, Enron, Merck and Schering-Plough – not many of which would be likely to find favour in a European ethical fund.
The Islamic Issues
In principle, all Islamic investing is by definition ethical. The small but growing number of Islamic investment trusts and other mutual funds will generally ensure that all their investments are screened by religious councils which have the power to rule on the acceptability of each company in turn. We've already mentioned the general ban on alcohol, pork products and tobacco; but these funds will also rule out any companies that are involved with abortion, human cloning and most other forms of scientific interference with nature.
Shari'ah principles exclude investing in any company with heavy debts, or one which earns a large proportion of its revenues by charging interest. The British-based IslamiQ fund, for example, rejects any financial institution that offers interest-bearing bonds, certificates of deposit or money-market funds. And it specifies that even non-financial companies are required to keep their debts down to within 33% of their total assets.
Investors wishing to adopt an Islamic investment policy may be interested in checking the Dow Jones Islamic Market Indices (http://www.djindexes.com/jsp/islamicMarketOverView.jsp), which were formed in February 1999 and which track exclusively Shari'ah-compliant companies in nine different geographical and sectoral categories. The indices have suffered badly over the last 12 months, mainly because they are very heavily weighted with technology companies; but over the three-to-five year term they've produced an average annualised gain of more than 10%. Most committed Islamic investors say that they have no regrets, and no doubts that it'll start to improve soon.
Among the new entrants has been Germany's Commerzbank, which has designed its AlSukoor European Equity Fund for the use of Muslims in the Middle East and in Europe. The British-owned HBSC and Barclays, and the Swiss UBS also have ethical funds designed for Middle East investors – and America's Citibank also runs an Islamic fund, though many Muslims reject it because of Citibank's interest-charging policies.
Other ethical investors are likely to find that the UK-based Ethical Investment Research Service (http://www.eiris.org) provides a sound (though European-oriented) starting point for choosing a portfolio – plus a very long list of suitable funds. Those looking for a North American approach would probably do better consulting the Domini 400 Web site (www.domini.com) or the Social Investment Forum (http://www.socialinvest.org).
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