60 Financeandeconomks

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 high-
er-margin international franchise (despite
asset disposals, half of the firm's general-
insurance sales are made abroad) is grow-
ing 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 retire-
ment-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 ex-
tended in frothier times. In common with
rivals, it is now changing its focus towards
products which are less sensitive to inter-
est 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 sav-
ings 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 deriva-
tives on its books, a small slice of its pre-cri-
sis $1.8 trillion portfolio but still nearly
three times its market capitalisation. The
firm also holds more sub-investment-
grade 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 Ben-
mosche is 68 years old and was diagnosed
in 2010 with an unspecified cancer) is Peter
Hancock, who now heads the general-in-
surance division but is famed in financial
circles for having pioneered credit deriva-
tives 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 ac-
counting 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-
TheBigMacindex
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 "in-
creasing politicisation of exchange rates".
Bill Gross of PIMCO, a huge bond-fund
manager, reckons the world is entering a
spiral of competitive devaluations remi-
niscent of the 1930S, as economies anxious
for growth massage their currencies down-
ward 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 pur-
chaSing-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 Mc-
Donald'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 dol-
lar is roughly 24% overvalued relative to its
American counterpart. In Mexico, by cQn-
trast, a Big Mac is just $2.90 at market ex-
change rates, suggesting the peso is 33% be-
low 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 curren-
cies are particularly overvalued in Nor-
Interactive Brg Macfndex: ,,'-

Thisweekwelaunch ournew
interactivecurrency-comparison
tool. Track the Big Mac index over
- __... time at Economist.com/bigmac
The EconomistFebruary2nd 2013
sode is now firmly in its past. The firm has
reverted to selling general insurance under
the AIG brand, having opted for the gener-
ic "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 Wash-
ington crazies deemed fit to salvage shows
it can compete with rivals who did not
benefit from taxpayer largesse. _
TheBigMacindex
Local currency under(-)/over(+) valuation
against the dollar. %
IBig Mac Price j
80 40 - 0 + 40 80
1].84] Norway
7.1 2 Switzerland
Brazil
I1:ill
Canada lTI[l
Australia gw
Euro areat 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
tWeightedaverageofmembercountries
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 min-
ister, Guido Mantega, who first trumpeted
the phrase "currency wars" in 2010. Brazil
battled back by introducing capital con-
trols in the form of taxes on foreign pur-
chases of Brazilian securities, but the cur-
rency remains overvalued. In December
Brazil notched a record current-account
deficit as its exports tumbled, contributing
to a slide in the economy's growth pros-
pects. Switzerland handled its overcooked
currency by pegging its franc to the euro in
2011. That halted the Swiss franc's appreci-
ation against the then-beleaguered single
currency, although not against the dollar.
Currencies in much of the emerging
The Economist February 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 rely-
ing 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 di sguiSing a fundamen-
tal hiftwithin the market. " alue" stocks,
in Europe at least, are starting to outper-
form 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 clas-
sifications is not cut and dried, "Market
commentators and investment managers
who glibly refer to growth and value
styles as contrasting approaches to invest-
ment are displaying their ignorance, not
their sophistication," is the warning of
Warren Buffett. The noted American in-
vestor 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 pre-
sent value of future cashflows, discount-
ed at the relevant rate, Predicting the vol-
ume of those cashflows and picking the
right discount rate are the tricky bits. Both
value and growth investors have to per-
form the task.
Notwithstanding Mr Buffett's caution-
ary 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 in-
vestors examine companies where the
underlying conditions 1001< more promis-
ing but where the marl<et may still be un-
..
derest imating the potential for long-term
profits growth.
A value investor would usually expect
a decent dividend yield; a growth inves-
tor would be happy if the company was
reinvesting aU its free cash. A value inves-
tor might be looking at a company with
shares trading at a discount to its asset val-
ue; a growth investor might not worry if
na posted a larger-than-expected $36.1 bil-
lion 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 econ-
omy 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% underva-
lued 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 tan-
gible 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 inves-
tors flocked to buy stocks in "new econ-
omy" companies with no profits or divi-
dends and scorned "old economy"
companies with established brand names
and solid cashflows, The vast gap between
the two caused consternation among tra-
ditional value managers like the late Tony
Dye at Phillips &Drew, a British fund man-
ager; clients deserted by the score,
Once the dotcom bubble burst, the val-
ue 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 out-
look for their business or industry, Inves-
tors became more risk-averse as the crisis
took hold and they tended to shun the val-
ue 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 growthindices
January 1st 1997-\00
180
Europe
160
140
120
100
80
60
; I I I
40
1997 2000 05 10 13
Source: TttOJTi!Cfl ~ u t r s
Finance and economics 61
chippy. The euro is now around 12% too ex-
pensive relative to the dollar, according to
our gauge; in the summer of 2012 it was
close to fair value. The euro has strength-
ened in recent months as fears of a euro-
area 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, in-
cluding the Federal Reserve and the Bank
of England, have acted aggreSSively to add
sauce to their economies. If the single cur-
rency 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 underperfor-
mance, 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 his-
torical terms.
Even so the stockmarket is not typical-
ly a place where investors can find lot of
$100 bills lyi ng around. Four sectors are
prominent in the value category: energy,
financial services, telecoms and utilities.
All are potentially the object of govern-
ment interference in the form of regula-
tion, 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 un-
der pressure, the risk of adverse develop-
ments 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 Janu-
ary and the potential for spending cuts in
the spring. American consumer confi-
dence 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