Henry Fernandez: We Are at an Inflection Point

Monday, 25 Oct 2010 | 10:21 AM ET

Although much of the talk going into the midterm elections is about jobs, taxes, health care and the domestic economy, many investors are attempting to get a view on the direction of the broader global economy.

Have the emerging markets become too hot to handle? Will financial regulation in Europe and the US push transactions into Asia? Are financial markets really healthier than they were during the crisis or is this just an illusion created by cheap money and bailouts?

I put these questions to Henry Fernandez, president and CEO of MSCI, which is the 800 pount gorilla in the international equity indexing market.

HF: What is going on in the world right now, is there's a lot of focus on the global economy and the impact on the global financial markets. There is an inflection point here as to whether we are going into deflation or inflation and what that translates into is a lot of volatility.

There's no direction right now. So what our clients are trying to understand, is what does that mean for the positioning of their portfolio? What is the risk if there was a significant downdraft in the financial markets? What is the draw down on their portfolios? How do they position themselves against that?

On the other hand, if there were to be a return to some level of growth, what are the bets they should be making for that. So for example, clearly there is emphasis on how much you should have in inflation adjusted linked bonds as well as how much growth stocks say in emerging markets should you have for it to balance out the risk and return of a portfolio.

LL: Speaking of the emerging markets, the BRIC countries have been on fire. Are you seeing more investors flock to the emerging markets?

HF: For sure they are. Because that is in the balancing act of risk and return.The return part is growth oriented and there for those are the only places that are creating a lot of growth in the economy and in the financial markets.

On the risk part, people are asking, to what extent are we in a BRIC bubble and therefore how do I protect my portfolio against that now.

As we speak, there is a little bit of exuberance going on in the emerging markets. The question really is when will we return to some level of growth in the developed markets, and what will that do to the financial markets in emerging markets.

In the world we live in today, there is a huge amount of assets that have gone into emerging markets, and therefore at some point that will reverse itself. And the question is when is that going to happen and where is it going to go. And will will the impact be on currencies and on the equities or the bonds of these countries. But for sure, there will be some reversion to the mean at some point.

LL: Are you seeing any interesting trends based on your indicies?

HF: When you look at a variety of the indicators you see there is a sense of stability in the world. The financial markets are not about to come unglued. There is a sense that is only a question of what is the direction of the global economy— is it going to recover at a slow pace, or faster pace?

I know on one hand there are some people that think there is a double dip coming. But what the indicators are pointing to is a very strong health of the financial markets. There are clearly some issues of currency valuations—what is undervalued, what is overvalued and you can argue all day long about that, but ultimately what we see in the indicators is a healthy financial market and its just a question of what is the overall direction of the global economy.

LL: The midterms are almost a week away and we are just at the very beginning of the process in writing the rules for financial regulation. How will the new Congress impact this?

HF: We are now living in a post crisis environment in which there is a re-look at the role of free and unconstrained capitalism. There is a big debate going on right now whether you end up with a European type of model in the U.S. or end up with more of a South East Asian model of a freer flow of funds.

Clearly, there are a lot of initiatives and in Europe on how to re-regulate the financial services industry, many of the hedge funds, investment banks and all of that. Some of this is already beginning to happen, but some of this may get derailed on who ends up in political office.

I think what we need to do is sit back and say what are the roles of all these different market participants and what is the best way the markets can function properly to let them do what they do best. That is allocate capital depending on the risk return profile that they have. I'm not a fan of significant regulations that would put a significant burden on market participants in the financial markets, but on the other hand, you have to have some certain rules of engagement in these areas.

LL: But I think with all the emphasis coming out of Congress on new, tougher regulations, there also needs to be a follow through on enforcement.

HF: Exactly. Enforcement is sometimes even more important. You can have relatively weaker laws, but if you enforce them properly, you end up getting a big bang for the buck to the extent that you have perfect rules and you didn't enforce them. There is a saying, the enemy of a good plan is a perfect plan, so when people are trying to write the perfect set of regulations they will be useless unless you have a monetary mechanism that can enforce them.

LL: With all the talk of increased enforcement in the United States, many of my contacts are worried that if the rest of the world does not get on the same page, the U.S. financial industry will be at a huge disadvantage and we might see some institutions go overseas to operate. Do you agree?

HF: For sure. What the world is lacking unfortunately right now is some form of global governance and regulatory systems. It is very easy in a global financial market system that we have today to arbitrage regulators around the world. A lot of hedge funds do that over time, some investment banks do that.

I think net net, given the direction we are seeing you'll end up experiencing some higher level of activity in Asia particularly in areas like Singapore and Hong Kong which are less regulated and away from the big financial centers of New York and London given the tight regulatory platform that are being put in place.

LL: Do you think we can ever have global regulation?

HF: At some point we are going to have to. It all depends on how we muddle through to get there.

The world is shrinking very fast. The financial crisis showed us that. So its either two alternatives: we go back to some level of restriction of financial flows in the world, or we end up in a world in which there is a significant amount of liberty to invest anywhere you want. But you have to do it in some sort of global framework as to what the rules of engagement are.

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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."


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