RJH writes...

'But why drives on that ship so fast, Without or wave or wind ?'

from "The Rime of the Ancient Mariner"

The Baltic Dry Index (BDI) is a measure of shipping rates paid to move ocean freight worldwide. Since it measures paid prices the index reflects real economic activity: it is not an index based on opinion, speculation, greed or fear. Its trend is therefore a useful yardstick against which investment market levels can be judged.

Traders of US 10-year Treasury notes have usually forecast economic prospects as reflected by the BDI correctly. Indeed, 10-year Treasury yield data has led the BDI with two exceptions in the last decade. The first of these began in the summer of 1995 when (unshippable) telecoms and IT equities sailed forward on a sea of Fed liquidity despite a falling BDI; and the second began at the trough of the market fall in spring 2003 when investors were fearful of buying equity - even as the BDI shot up.

It may be time to write-up a third divergence. At end February 2005 the BDI and the 10-year Treasury appeared to part company.

Exhibit A: BDI and Ten-Year Treasury Yields - you take the high road

With the BDI at the time of writing at 2,407 it is still at heights unscaled before 2003. However, if it goes below 1,750 with conviction - and it was at 1747 this summer - the index will simply be reverting towards its long-term mean. This is not merely technical-analyst talk: there are sound reasons why this is likely, covered here by the Economist magazine.

Treasury yields, meanwhile, have been insensitive to these developments and are continuing to reflect - perhaps above all - just how much cheap money is sloshing around. Nonetheless, for the businesses and sectors exposed one way or another to shipping activity the outlook is distinctly gusty to gale-force:

Exhibit B: BDI and Clarkson Plc, the world's largest quoted shipping broker

Clarkson Plc is an excellent company in which this scribe owned equity until earlier this year. Why sell? Because the trend of this graph suggests that investors in companies exposed directly and indirectly to shipping markets (or both, as in Clarkson's case) have continued to buy into the boom story (China, commodities, emerging market strength et al) even as demand for freight services tapers away.

Does this herald a fall in world stock markets? In itself, no. Yet it is certainly not a good sign that aggregate demand for shipped goods and raw materials is dropping sharply. Markets do not seem to be paying attention so far: the example above of Clarkson plc is a proxy of a more general observation. However, as in 1995, it is always possible market leadership may come from sectors unconcerned with freight rates and activity. But that would be a courageous and potentially expensive passage for investors to book.

Happy New Year.

Credits: The 10 year Treasury / BDI background (para 2) comes from a 2002 article by Howard Simons.

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RJH writes...

Increased merger and acquisition (M&A) activity is cited by several equity research desks in the City of London as a catalyst for positive investment returns on the London financial markets in 2006.

Indeed, in 2005 so far the purchases of O2 by Telefonica for £17.7bn and Allied Domecq by Pernod Ricard for £8bn have probably helped propel the markets. Premiums paid on such deals in addition to the reinvestment by fund managers of proceeds received are doing their part in a solid year for gains.

At the aggregate level, foreign purchases in 2005 year-to-date have been enough to make the UK a net seller of its companies to overseas investors. 2004 was also a net sale year for the UK with M&A dominated by the purchases of Abbey National by Santader Central Hispano for $15.8bn and Amersham by General Electric for $9.6bn. At end 2004, 33% of all shares listed on the London Stock Exchange were held by overseas investors. That is about the same as the combined percentage controlled by UK insurance companies and pension funds.

Long live the open economy but, without overstating the argument, as companies like these pass into foreign ownership and out of domestic bourse listing the UK investment prairie shrinks; companies smaller than those acquired become included in the main indicies such as the FTSE100; investment focus is forced upon less than large caps; management of investment risk becomes more important; and strategic/political worries about ceding control of domestic companies to foreign interests become sharper.

And at the extreme end of the argument there is the impact on the financial account of the balance of payments to consider - essentially, asset sales to help fund a persistent current account deficit. Temporary comfort but longer term difficulty.

So what has been the longer term trend of M&A in the UK?

Exhibit 1: UK abroad vs Foreign into the UK M&A, 1987-2005 ytd

It turns out that the UK is a net asset acquirer since 1987. The eleven years to 1997 saw cumulative net purchases by the UK of £20.6bn; and the next three years were dominated by a handful of monstrous deals which saw the UK become the new owner of £148.1bn of net foreign assets, most notably:

Amoco, bought by BP for $48.2bn

Airtouch, bought by Vodafone for $60.3bn
Astra, bought by Zeneca for $34.6bn

Mannesmann, bought by Vodafone-Airtouch for $202.8bn
Arco, bought by BP Arco for $27.2bn
Bestfoods, bought by Unilever for $25.1bn
Credit Commercial de France, bought by HSBC for $11.1bn

But since 2000 the UK has lost net assets of £14bn to foreign interests and, compared to the pre-1998 period, that is a sharp deterioration. It is in that context that the predictions of bonus-minded investment bankers sit: 2006 will be a bumper M&A year - deals as large as £50bn will reappear and, it is claimed, never has there been such a good time to sell. Find a credulous buyer and let the good times roll.

It will be fascinating to see how this potential cookie crumbles for the UK's net M&A position. Equally, the composition of such deals (what mix of debt, cash and equity) in what may well be a deteriorating macro-economic picture 12 months down the road may be entertaining - can you say "3G auction"?

Sources: UK's Office for National Statistics; UNCTAD World Investment Report (various years)

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RJH writes...

Keeping with Wednesday's theme, but with less words.

Exhibit 1: UK inflation expectations against the AIM

Another reason, if you needed one, to avoid or select carefully amongst equities majority exposed to the UK economy.

Sources: Bank of England; Yahoo UK Finance

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