Thursday, September 26, 2013

Financial Market Risk Alarm Bells Should Be Ringing; Instead: Silence. Uh Oh.

On this website, special care is made to highlight the risks inherent in the various investment themes and economic developments covered. Put another way, an attempt is made to shine light on potential outcomes that may proverbially blow one’s fingers off. Despite receiving top billing in the bedrock investor paradigm of risk/reward, the concept is risk is often overlooked by many casual, and sometimes professional, market participants. The emphasis on seemingly sure-thing rewards is only aided by the torrent of rosy forecasts by policy makers and brokerage firms, not to mention ubiquitous television commercials where one is led to believe that every investor is an uber-fit, 50-something male, successfully trading from his veranda overlooking the Pacific coastline.

Yet recent history is filled with examples of the carnage that ensues when investors either misprice risk or patently ignore it altogether. We had the exuberance of the bubble, the cleverly dises of the carnage that ensues when investors either misprice risk or abjectly overlook i-engineered mortgage backed securities meant to diffuse risk, which in the end turned out to be not-so cleverly engineered, and presently U.S. equities are hitting record highs, despite dubious fundamentals and weak economic growth. In this most recent iteration, one cannot entirely blame investors for grossly deviating from what sound math might otherwise lead them to believe the intrinsic value of securities to be; instead they have been pushed into asset classes further out along the risk spectrum as the Federal Reserve crowds out safer investments, which would otherwise be more appropriate for portfolios during a period of uncertainty and tepid growth. This distortion of demand for riskier assets has been a pivotal factor in allocation decisions for the past three years. Not good. Think of startled lemmings and their fate just beyond the cliff.

Peeling Back the Risk Onion
Any economic endeavor entails risks. Start a business and you are putting your capital on the line. Buy a house and the market may tank or obnoxiously loud Broncos fans may move in next door. Risk is inherent in financial markets. Yet not investing invites risks of its own, especially when factoring in longer life expectancy (a good thing), a lack of savings my most Americans (a bad thing) and the house-of-cards financing of the social security system (something abhorrent). Once in the market, the calculus becomes only more complicated. As a result of the Fed’s Treasury purchases enabling bloated deficits, everyone is exposed to the risk of a declining dollar….. that is monetizing the debt, making it vanish through inflation. This generational theft punishes savers the hardest, especially those whose portfolios are geared towards the cash-producing fixed-income instruments most sensitive to inflation.

But these hurdles exist too far out into the future to rattle the average short-sighted American (and especially his/her elected leaders). There are, however, plenty of immediate economic and investment risks to keep us awake at night. Thanks to the massive shadow of the Fed’s accommodative policies, many of these are either directly or indirectly tied to the central bank’s future moves.  These risks are manifested in different ways across asset classes. Additionally, specific forms of investments have acute risks based on their inherent characteristics. The textbooks call this diversifiable risk, but as 2008 brutally illustrated, that term proved a bit elusive.

The Fed’s Long Shadow
Much of the conversation surrounding the Fed’s quantitative easing has been on its demand for Treasuries. Lost in this is the torrent of supply emanating from the federal government. While down from its crisis peak of 13% of GDP, the government deficit remains elevated. Given weak growth, revenues from taxation on a (welcome) increase in economic activity remains a pipe dream. Furthermore, gross government debt has crested 100% of GDP and is expected to remain there for the foreseeable future. Most troubling is the deficit is effectively being subsidized by the rock-bottom interest rate regime in place since the advent of QE. Should rates begin to creep up…as had begun to occur beginning in May, before Chairman Bernanke quashed tapering talk…..the interest rate component of the deficit will rise, shooting the debt into even more stratospheric territory. Throughout the 1980s and 1990s, federal government interest payments averaged 2.8% of GDP. During the great moderation of interest rates during the early 2000s and into the post-crisis QE era, the average has fallen to 1.6%. Should rates normalize, interest payments on government debt will make solving chronic deficits all the more arduous. We call that a death spiral.

Given the status of U.S. Treasuries as the…..ahem….risk free benchmark for much of the investment universe, the deficit/debt conundrum will have repercussions far beyond the market for U.S. government paper. One potential flashpoint will be the dollar. The risk….well temptation….to vaporize the debt via the continual torrent of fiat dollars could catalyze persistent inflation, which when unleashed, would prove difficult to reign in.  These debt levels, along with a weaker dollar, could finally cause major investors, namely foreign central banks, to dial back their exposure to U.S. government securities. The ensuing drop in demand and consequential rise in interest rates would serve has yet another drag on business expansion and consumption. Not what the economy needs.

Bonds: Not the Safe Haven of Yesteryear
The worst kept secret in financial markets today is the risk facing fixed-income instruments once the Fed pulls back its support for bond market. At a yield of 0.34% on the 2-Year and 2.6% on the 10-Year, it does not take much of a drop in principle to wipe out any coupon payments attached to these securities.

The first destination along the risk spectrum for investors seeking to meet their investment obligations is the corporate bond market.  As seen below, yields on investment grade corporate debt reached record lows during 2012, following the trajectory of the 10-Year benchmark, and have only slightly risen since then. The spread on BAA bonds over benchmark is only 268 basis points, compared to a post-crisis average of 319 bps. In the absence of interest rate support from Fed purchases in addition to spreads rising once investor demand cools, prices across the fixed income universe likely have only one direction to go: south.

Stock Market Optimism….Or Complacency
When viewing the path of the S&P 500 over the past two years, one could deduce that there is not a care in the world. This is compounded when noticing that the VIX Index, the market’s fear gauge and thus a measurement of risk aversion, is 40% below its long-term average.

Fed policies have certainly pushed yield-starved investors into equities over this period, raising prices along the way. Corporate income statements have also benefited from the low interest rate environment by locking in long-term financing at a bargain. Even if rates start to climb, stocks could see a benefit if a) it was a consequence of the sustained economic growth needed to fuel top lines, and b) it loosened up the purse strings of banks to make more loans at a respectable profit. The flip side is that loans that have already been made….and there has indeed been progress on this front…could see their rates reset at a higher level. This is especially the case for firms with more questionable credit quality.

The other main risk to equities is that investors may finally wake up. One major driver of stocks (GDP growth) has been a dud and another (productivity gains) have been squeezed dry. According to S&P data, EPS growth has slowed to a snail’s pace. Despite this, the forward P/E ratio of the index presently sits at 14.7, still marginally attractive. Investors have continued to focus on the fact that in relative terms equities remain cheap, but that does not factor in the suspect landscape. Should a rerating occur, say down to a more plausible P/E ratio of 13, the S&P 500 could lose 12%. And that is keeping forward earnings estimates constant, ignoring the recent history of expectations being repeatedly pared. Should that plausible scenario occur, a sell-off could potentially reach bear market territory.

Next Stop Along the Risk Spectrum: Emerging Markets
Emerging market investors (and policy makers) were the first to experience the volatility caused by Fed intervention into financial markets. As seen below, once the FOMC opened the door to the possibility of tapering bond purchases in May, the MSCI Emerging Markets Index lost 17% in short order. While much of that has been recovered, the fall shows how sensitive these markets have become…rightly or wrongly…to the perceived support of risky assets by Fed policy. The remainder of the chart illustrates the volatility inherent in emerging markets as hot money investment flows often overshadow country specific fundamentals. Maybe it’s not fair, but that’s how the game is played these days.

With regard to country-specific risks, the laundry list of potential red flags in emerging market investing is well-known: opacity, illiquidity, lousy shareholder rights, corruption, populist protectionism (which could apply to certain unnamed advanced economies as well), and a weak track-record of fighting inflation and currency instability. It is with irony that many emerging market policy makers complained first about hot money inflows on the back of QE only to gripe even more when flows reversed, weakening their home currency and igniting fears of imported inflation. Yet distorted demand for emerging market assets is also providing a window of opportunity for countries to reform their economies and institute sound fiscal and monetary policy. Once QE ends….as all good things must….investors will seek out destinations which made strides in positioning their economic systems for the next iteration of growth. Others could follow the path of Argentina.

Commodities: Can Fundamentals Rule the Day?
If we had had a conversation about the relationship between Fed policy and commodities three years ago, the tenor would have been entirely different. From the onset of the financial crisis to the announcement of QE2 in August 2010, the SPGSCI Commodities Total Return index bumped along the bottom. After Chairman Bernanke’s Jackson Hole speech that month, the index shot up 42%. This led to cries of commodities bubbles fueled by loose monetary policy. While there still may be something to that argument (we’ll save it for another day), fundamentals have for the most part retaken their position as the main driver in commodities pricing.

Being the role commodities play as key inputs in industrial applications….and in our mouths and gas tanks…. fundamentals are largely determined by economic growth.  And therein lies the rub. Growth…even in emerging markets…has yet to return to pre-financial crisis levels. The consequent lack of demand has kept a lid on many industrial inputs. What’s more, the buy-in of the commodities supercycle concept was so strong that buckets of capital investment and technological innovation were deployed to meet rosy future demand projections. This new pipeline of supply, when accompanied by soft-demand, presents downside risks to the prices of securities associated with the commodities space. North American shale oil and natural gas are prime examples of the shift from strong demand factors to abundant supply steering the market. At least with commodities, the cost of production sets a floor to prices, as producers will idle capacity once prices dip below that level.

Headline Risk
Can we discuss risks to financial markets without mentioning contemporary headline-grabbing developments such as the misfiring Arab Spring and the carnage in Syria? While these events may cause ephemeral spikes in oil prices, one must remember that neither Syria nor Egypt have significant crude reserves. Yet there is real political risk to developments in the Middle East, not only due to the fact OPEC continues to account for roughly 40% of global oil capacity, and the shipping lanes of Hormuz and Suez could easily be compromised, but also because of the simmering Shia/Sunni sectarian violence that is manifesting itself across the region. There is a lot of oil within close proximity of that fault line.

The latest round of Washington’s budget and debt ceiling battle also provides fodder for the financial press.  While any impact on markets may be short-lived, some good may be served by shining a light on the government’s aforementioned debt/deficit problems. Or the can once again gets kicked down the road, which will only magnify market…and real economy…risk once the day of reckoning arrives.

With the launch of major parts of Obamacare only months away, opinions abound as to whether there will be aggregate cost savings or greater outlays required of business and consumers. Time will tell, but as a rule, greater regulation, either in healthcare, energy or financial services, often leads to great ossification of the economy. Just ask France. This is not what timid corporate managers or chronically underemployed consumers want to experience if either group is expected to contribute to the economy ever reaching escape velocity from this drab new normal.

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