60 Finance and economks

~ vals-stories abound of AIG units bidding against each other for contracts. Bad luck hasn't helped. Hurricane Sandy will have dented fourth-quarter profits to the tune of $2 billion before tax, the most of any American insurer (it also flooded AIG'S wall Street offices).

The good news is that insurance prices in America are rising, and that AIG'S high­er-margin international franchise (despite asset disposals, half of the firm's general­insurance sales are made abroad) is grow­ing fast. More controversially, the company is also cutting reinsurance coverage, which is how insurers offload their own risks. This will juice margins but could lead to AI G shouldering larger one-off losses.

The impact of low interest rates is even greater for its life-insurance and retire­ment-planning business, which makes up the other half of the group's earnings. Many of its life products offer customers fixed returns on premiums paid. AIG has limited flexibility to lower the rates it ex­tended in frothier times. In common with rivals, it is now changing its focus towards products which are less sensitive to inter­est rates. But lower returns and a still-soft economy also has the effect of dampening interest from consumers, who appear keener to squirrel away money into sav­ings products when they feel rich. Profits in this area of the business are expected to be flat for the foreseeable future.

Bits of AIG continue to baffle outsiders. It still holds $158 billion of credit deriva­tives on its books, a small slice of its pre-cri­sis $1.8 trillion portfolio but still nearly three times its market capitalisation. The firm also holds more sub-investment­grade securities on its balance-sheet than any of its life-insurance rivals, according to J.P. Morgan. Much of this exposure comes from mortgage-backed securities taken over by ihe government during the crisis and subsequently repurchased by AIG.

"We have a detailed understanding of these assets," says Mr Benmosche. Maybe so. His most obvious successor (Mr Ben­mosche is 68 years old and was diagnosed in 2010 with an unspecified cancer) is Peter Hancock, who now heads the general-in­surance division but is famed in financial circles for having pioneered credit deriva­tives at J.P. Morgan two decades ago. But however well AIG understands itself, many analysts quietly admit that parts of the group's finances are still hazy to them.

Investors are nonetheless bullish on the shares. T.hat is partly because they trade at just over half AIG'S book value, whereas other insurers are trading closer to or above book value. Investors like the regular recent payouts of excess cash to shareholders, although the firm's focus is now expected to be on paying down debt to maintain its A- credit rating. Huge ac­counting losses during the crisis will lower AIG'S tax bill for the next few years, bol­

steting profits. And although some fret about a tighter regulatory regime, with the Fed likely to impose bank-like "stress tests" from 2014, others see stricter supervisory oversight as a reassuring plus given the group's recent history.

AIG certainly has a new-found air of confidence. A recent ad campaign featured its employees thanking America for the bail-out, implying that this unpleasant epi-

The Big Mac index

Bunfight

WASHINGTON, DC

Currency wars: the burger's verdict

AN OLD beef is again dividing the world fiof international finance: the spectre of "currency wars". Jens Weidmann, the head of Germany's Bundesbank, recently fretted that central-bank efforts to revive flagging economies could lead to an "in­creasing politicisation of exchange rates". Bill Gross of PIMCO, a huge bond-fund manager, reckons the world is entering a spiral of competitive devaluations remi­niscent of the 1930S, as economies anxious for growth massage their currencies down­ward to give exporters a boost. What does burgernomics have to say?

The Big Mac index is The Economist's lighthearted analysis of foreign-exchange rates. Its secret sauce is the theory of pur­chaSing-power parity (ppp), according to which prices and exchange rates should adjust over the long run, so that identical baskets of tradable goods cost the same across countries. Our basket contains only a Big Mac, and relies on the efforts of Mc­Donald's to produce identical products from the same ingredients everywhere (or almost everywhere: for India we use the Maharaja Mac, which contains chicken rather than beef).

At market exchange rates, the Canadian version of the burger costs $5.39, compared with an average price of $4.37 in America. By our reckoning, then, the Canadian dol­lar is roughly 24% overvalued relative to its American counterpart. In Mexico, by cQn­trast, a Big Mac is just $2.90 at market ex­change rates, suggesting the peso is 33% be­low its long-run value relative to the dollar. The greenback buys much more Big Mac south of the border than north of it.

The Big Mac index suggests that curren­cies are particularly overvalued in Nor-

Interactive Brg Macfndex: ,,'­

1~~:Ili~. This week we launch our new ~ interactive currency-comparison

.·~~m~ tool. Track the Big Mac index over ••-__... time at Economist.com/bigmac

The Economist February 2nd 2013

sode is now firmly in its past. The firm has reverted to selling general insurance under the AIG brand, having opted for the gener­ic "Chartis" at the height of the crisis. By any measure, this has been a remarkable comeback. But it will be sealed only when the insurance company that those Wash­ington crazies deemed fit to salvage shows it can compete with rivals who did not benefit from taxpayer largesse. _

The Big Mac index Local currency under(-)/over(+) valuation against the dollar. % IBig Mac Price j

80 40 - 0 + 40 80

1].84] Norway

7.1 2Switzerland

Brazil I1:ill Canada lTI[l Australia gw Euro area t gru United Statesl gm Britain 4.25

Japan !IID Mexico IIW Indonesia a:;:m China§ = lIill -Russia u;m -Egypt IIID -Hong Kong IIill South Africa 2.03

India·" 1.67

'At market exchange rates (Jan lOth 20B) .3

tWeighted average of member countries tAverage of four cities §Average of five cities

Sources: McDonald's: The Economist ··Maharaja Mac

way, Switzerland and Brazil (see chart). The continuing strength of the real is a big source of irritation to Brazil's finance min­ister, Guido Mantega, who first trumpeted the phrase "currency wars" in 2010. Brazil battled back by introducing capital con­trols in the form of taxes on foreign pur­chases of Brazilian securities, but the cur­rency remains overvalued. In December Brazil notched a record current-account deficit as its exports tumbled, contributing to a slide in the economy's growth pros­pects. Switzerland handled its overcooked currency by pegging its franc to the euro in 2011. That halted the Swiss franc's appreci­ation against the then-beleaguered single currency, although not against the dollar.

Currencies in much of the emerging ••

The Economist Feb ruary 2nd 2013

~ world, including Russia, China, and India, are too cheap relative to the dollar on our gauge. Critics of burgernomics say that you would expect average prices to be cheaper in poor countries than in rich ones becau e labour costs are lower: PPP signals where e change rates should head over the long run, as a country like China gets richer. nm where prices should be right nov;. Even 0 the perennially undervalued yuan ha_ caICely moved towards the Big Mac lEasure of fair value. That, many reckon. is Gown to meddling by the chefs at the Peopk' Bank of China, who are rely­ing 0 export growth for sustenance: Chi-

Buttonwood !

Fashions are changing in the stockmarket

I s IT lime for a ange in investment style? The general ri e in stockmarkets

this year may be disguiSing a fundamen­tal hiftwithin the market. " alue" stocks, in Europe at least, are starting to outper­form tho e in the "growth" category after five years in which the trend has been the other way round (see chart).

The distinction between the two clas­sifications is not cut and dried, "Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to invest­ment are displaying their ignorance, not their sophistication," is the warning of Warren Buffett. The noted American in­vestor looks for a hybrid: companies that can grow their future earnings but are priced cheaply relative to what he dubs their "intrinsic value".

The right price of any stock is the pre­sent value of future cashflows, discount­ed at the relevant rate, Predicting the vol­ume of those cashflows and picking the right discount rate are the tricky bits. Both value and growth investors have to per­form the task.

Notwithstanding Mr Buffett's caution­ary words, the two groups tend to search in different places, Value investors look at stocks that are in unglamorous industries or at companies that have suffered a bout of bad news in the recent past. Growth in­vestors examine companies where the underlying conditions 1001< more promis­ing but where the marl<et may still be un­.. derestimating the potential for long-term profits growth.

A value investor would usually expect a decent dividend yield; a growth inves­tor would be happy if the company was reinvesting aU its free cash. A value inves­tor might be looking at a company with shares trading at a discount to its asset val­ue; a growth investor might not worry if

na posted a larger-than-expected $36.1 bil­lion trade surplus in December, thanks to 14% growth in exports year-on-year.

Japan is the country that caused the most recent talk of currency battles. The new government's plan to reflate the econ­omy with fiscal and monetary stimulus has helped drive the value of the yen down in recent months. The Big Mac index put the yen close to fair value against the dollar in July; it is more than 19% underva­lued now. That's a tasty development for Japanese exporters but indigestible news for rivals.

Europeans are feeling particularly

the company had much in the way of tan­gible assets at all. To caricature the divide, the growth investor might pick Google and the value investor would opt for Aitria, the tobacco firm once known as Philip Morris.

The moment when this divide seemed starkest was in the late 1990S when inves­tors flocked to buy stocks in "new econ­omy" companies with no profits or divi­dends and scorned "old economy" companies with established brand names and solid cashflows, The vast gap between the two caused consternation among tra­ditional value managers like the late Tony Dye at Phillips &Drew, a British fund man­ager; clients deserted by the score,

Once the dotcom bubble burst, the val­ue style outperformed for several years, before the financial crisis of 2007 and 2'008 heralded yet another change in fashion, Value stocks are usually cheap for a reason, There is deep uncertainty about the out­look for their business or industry, Inves­tors became more risk-averse as the crisis took hold and they tended to shun the val­ue category as a result.

So what is driving the recent uptick in value stocks? One reason is greater opti-

Turn again MSCI I/a ue indices as % of MSCI growth indices January 1st 1997-\00

180 Europe

160

140

120

100

80

60 ; I II 40

1997 2000 05 10 13

Source: TttOJTi!Cfl ~uters

Finance and economics 61

chippy. The euro is now around 12% too ex­pensive relative to the dollar, according to our gauge; in the summer of 2012 it was close to fair value. The euro has strength­ened in recent months as fears of a euro­area break-up have receded, but many Europeans also point the finger at currency manipulation, The European Central Bank has done little to boost an ailing euro-area economy even as other central banks, in­cluding the Federal Reserve and the Bank of England, have acted aggreSSively to add sauce to their economies. If the single cur­rency keeps rising, euro-area exporters will end up in a pickle . •

mism about the outlook for the global economy as fears of a euro-zone break-up and a Chinese hard landing have receded. Furthermore, after years of underperfor­mance, value stocks look like a bargain. Matthew Garman, a strategist at Morgan Stanley, reckons that European value stocks now trade at a 47% discount to their growth counterparts, a wide gap in his­torical terms.

Even so the stockmarket is not typical­ly a place where investors can find lot of $100 bills lying around. Four sectors are prominent in the value category: energy, financial services, telecoms and utilities. All are potentially the object of govern­ment interference in the form of regula­tion, higher taxes, limits on their ability to raise prices, higher capital requirements (for the banks) or outright nationalisation (mining and oil companies in developing countries). With government finances un­der pressure, the risk of adverse develop­ments for these industries must be greater than normal.

The other risk is that global growth may not be as strong as investors hope. European economies look stagnant; American growth, which turned negative in the last quarter of 2012, may be held back by the tax rises agreed upon in Janu­ary and the potential for spending cuts in the spring. American consumer confi­dence fell to a 14-month low in January. Siower-than-expected growth might lead to lower commodity prices and to more trou ble for the banking industry.

Still, once stockmarket trends start to develop, history suggests they can last a long time. In America value stocks have underperformed growth stocks by 23% since the start of 1997. That leaves a lot of ground to catch up.

Economist.com/btogs/buttonwood