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Equity fund managers now know what a CDO is, notes CLSA’s Christopher Wood in his typically understated client newsletter, Greed & Fear. “An awareness of risk has clearly risen”, he notes. But Wood believes much of the anxiety among the fund managers stems from their holdings in Asia.

“Most fund managers would like to hedge their long Asian equity exposure by shorting credit spreads,” says Wood. “But most conventional long-only fund managers cannot put on such a hedge, which means a continuing desire by foreigners to invest in perceived ‘lower beta’ lagging markets such as Taiwan and Thailand.”

Overall, Asia and emerging markets remain in long-term bull markets, “which is why the most difficult question in Asia remains which market is relatively least attractive”, says Wood, noting that the emerging-market share of the MSCI AC World Index “is now back at the 1993 peak levels”. It is also just a matter of time, he says, before the Asia (ex-Japan) region breaches its previous pre-Asia crisis peak weighting.

Investors who have followed Greed & Fear’s “long-held advice” of being five times overweight Asia and emerging markets should now have 34 per cent and 48 per cent of their global equity portfolio invested in the respective asset classes, says Wood. The rest of a global equity portfolio should be allocated (geographically) in Japan, Germany and Nicolas Sarkozy’s France, “with also a sectoral allocation in gold and other resource plays,” he says.

But the fact that fund managers now want to talk about CDOs “might be a sign that in the short term, the market has overdosed on this issue”, says Wood. But, he adds, the timetable has now been fast forwarded by the credit agencies’ “sensible decision” last week to accelerate the inevitable downgrading of subprime bonds and CDOs.

And save any worry for later, because “even more bad news is coming from this area,” says Wood. Amid rising risk aversion, “investors should also watch for evidence of subprime problems moving into the Alt-A area of the mortgage market where activity has continued to boom”. It’s only a matter of time, he says, before risk aversion hits Alt-As, too.

The big-picture risk to equities, meanwhile, “remains deflation and not inflation, as reflected in the maniacal excesses now being exposed in structured finance and the resulting risk of wealth destruction”. From a free market perspective, “black box” credit funds are the obvious way of wiping out the wealth.

The other point to watch on structured finance is the LBO financing calendar and the ability of the LBO players to continue to finance their deals on terms that make sense. The financing pipeline is huge and spreads are rising. But so far the situation is manageable, says Wood.

Thank God for small mercies, then.