Rediscovering Risk

Amid all the day-to-day noise buffeting investors, it is all too easy to miss the implications of the massive big-picture trends that end up being much more important that any couple of passing profit downgrades or commodity price gyrations.
The trouble with the big picture is that you can’t see it what it looks like when you standing in the middle of the thing. For example, the collapse of risk premiums over the past few years of super-loose monetary policy has implications for all investors in all markets, but we tend to just march along oblivious to its existence, let alone its meaning.

A reasonable gradation of risk is necessary for rational investing '” but the rational risk premium has collapsed under the weight of loose monetary policy and the tsunami of investment dollars chasing a return.

The Wall Street Journal ran a major front page story last week on Stash Flow with one of their characteristic all-encompassing sub-headings: “Huge Flood of Capital to Invest Spurs World-Wide Risk Taking, Corporate and Foreign Savings Chase Assets, Driving Prices Up, Keeping Returns Low. A Global Game of Chicken."

Which is some ways pretty much sums it up. The Journal's report said:

"There's an unprecedented wave of capital flowing around the world, with all of its owners anxiously searching for a better return. World pension, insurance and mutual funds have $46 trillion at their disposal, up almost a third from 2000. In the same period, global central bank reserves have doubled to $4 trillion, and other gauges of available capital have risen as well.

"Meanwhile, world central banks have kept short-term interest rates low, even after the Federal Reserve's latest quarter-point boost. That means investors who put their cash in safe money-market paper can net only a modest margin above inflation.

"The result is that global investors are diving into a wide range of riskier assets: emerging countries' stocks and bonds; real estate and real-estate-backed debt; commodity funds; fine art; private-equity funds, which buy stakes in non-public companies; and the investment contracts called derivatives, including a kind structured to permit the sophisticated to take huge bond risks.

"For good measure, many investors use today's low interest rates to borrow money to amplify their bets. This 'leverage', in effect, thus enlarges the already overflowing pool of investment capital. As these markets draw more investors, whose buying pushes up their price, prospects rise that a reversal could cause widespread pain.

"Where does this global flood of cash come from? Ben Bernanke, the economist just nominated to head the Fed, last March identified what he called a 'global savings glut', which, he said, helps explain the relatively low level of long-term inflation-adjusted interest rates in the world."

Global imbalances also come into play with this investment glut. While Americans and Australians use their inflated home equity for investment, China’s export boom means they will have about $US116 billion to invest internationally this year (most of it going to the US to finance America’s imports of Chinese goods). We’ve previously reported on the new wave of petrodollars, with the Arabian Gulf states expecting a collective current account surplus of $US200 billion this year '” 20% of their GDP. Russia, thanks mainly to oil, will have a trade surplus of $US102 billion, the Journal says.

"Policy makers increasingly see worrisome consequences of this global cash surplus," it says. "As the price of an asset rises, the income it throws off '” a stock's dividend, a bond's coupon, a building's rent '” automatically declines as a percentage of the asset's value. This means investors are demanding less compensation than usual for taking on the risk inherent in owning the assets. In the lingo of economics, the "risk premium" is low today."

Investors tend to get hurt while standing in that big risk premium picture without even knowing what’s happening around them. The Journal again:

"'History has not dealt kindly with the aftermath of protracted periods of low risk premiums,' Fed Chairman Alan Greenspan noted in August.

"As investors pile into riskier assets and their prices rise, they generate impressive returns for those who own them and attract still more investors.

"Cautious money managers who play it safe and stay on the sidelines run the risk of showing embarrassing low returns, and losing clients. Most choose to stay in the game.

"'Investors' quest for higher returns can present a dangerous quandary,' says Jim Sarni, who invests for pension funds and insurance companies at a firm called Payden & Rygel in Los Angeles. 'It makes you continue to invest in higher-yield instruments despite the fact that spreads are narrow' '” that is, their return above safe instruments is small. 'So it becomes this vicious cycle,' Mr. Sarni says. 'It is a global game of chicken.'

The good news, or perhaps the bad, depending on how your portfolio looks, is that there are signs of a recovery in the risk premium.

Macquarie Securities' international economist, Mark Tierney, has been keeping a watchful and warning eye on the risk premium issue and the risk it poses for markets. In the accompanying video interview, he identifies the start of a change over the past few weeks that could have major ramifications for all investors.

The General Motors debt problems earlier this year and now Delphi have put a charge through the corporate debt market, but it goes further and is bigger than that. As the Federal Reserve increases interest rates, it will be the riskier investments that feel pain first and investors will re-discover what risk means. Tierney’s morning missives to clients have been well ahead of the Wall Street Journal reporting over recent months, but I’ll leave it to the Americans to throw in the scare:

"Some economists and policy makers say that risk premiums are bound to rise, which means many asset prices, from corporate bonds to real estate, would likely fall. No one is sure what the trigger would be.

"It's often something unexpected that investors haven't incorporated their forecasts. It could be that although many companies today are highly profitable and able to service their debts with little trouble, rising oil prices could hold back global growth and impair corporate creditworthiness. Witness the recent bankruptcy filings of auto-parts maker Delphi Corp, Northwest Airlines and Delta Air Lines, all of which burned holders of their securities.

"If the world's central banks boost short-term interest rates more sharply than expected to ward off inflation, investors might start selling some of their riskier assets in favour of newly attractive short-term instruments.

"The Fed has recently stepped up its anti-inflation rhetoric, and the European and Japanese central banks have indicated they may raise interest rates in the coming year.

"At the same time, corporations might revive expansion plans and become big borrowers again, pushing up long-term interest rates. Rising risk premiums, and thus falling asset prices, could then become self-reinforcing as leveraged investors unwind their positions to limit losses, driving asset prices down further and triggering still more selling.

"Under this scenario, the pain could spread to Main Street if newly risk-averse lenders demanded higher rates for mortgages. Rapidly rising mortgage rates could weaken housing prices."

One of the Fed’s great frustrations has been that lifting short-term interest rates has not flowed through to a rise in long-term US mortgage rates, allowing the housing bubble there to continue long after a nudge and a bit of jaw-boning by the Reserve Bank of Australia successfully started letting the steam out of ours.

Mark Tierney’s interview provides a chance to step back and have a look at the larger picture. For those subscribers with dial-up connection, a transcript will be provided with Wednesday’s edition of Eureka Report.