May 22, 2010
There was a time not so long ago when the markets were convinced that the risks the global financial crisis had exposed were contained. But that was then. Yesterday's market fightback aside, risk has been rediscovered and risk aversion is back in vogue.
It has been evident in the attack on the euro, the proxy for Europe's sovereign debt problem, and the message it sends that government debt taken on to save the financial system and prop up the global economy in 2008 and 2009 will be a long-term weight on growth everywhere.
It is also behind the Australian dollar's dive. The Rudd government's clumsily handled resource rent tax, signs of a pause on Reserve Bank rate rises and our commodity-heavy currency's vulnerability to concerns about global growth were other factors, as was a currency market version of programme trading. Selling by Japanese retail ''carry trade'' investors was triggered as the US dollar-yen rate moved below 90 yen and the Aussie-yen rate went below 75 yen. But however you cut it, what we are talking about is risk rediscovered and reinsured.
After misjudging how America's sub-prime property crisis would infect world markets, hedge funds and other big investors are determined not to be caught again, either by underestimating the possibility that Europe's sovereign debt crisis will fan out into a new systemic global crisis, or by mis-pricing the long-term impact of the debt-funded bailout.
The most fundamental risk insurance that investors take out is a fatter percentage return on the investments they make.
I can't tell you if hedge funds believe they have taken out enough insurance by beating down the quoted prices of shares and other vulnerable markers, including the euro and the Aussie. But I can tell you that insurance levels have been significantly increased worldwide.
In September the companies in the S&P/ASX 200 share index were promising to deliver earnings that equal a 5.9 per cent return on the cost of buying them. Totally safe 10-year Commonwealth bonds were yielding 5.5 per cent, so share investors were receiving a premium of less than half a percentage point for their higher risk, potentially higher return sharemarket exposure.
After this month's slide, the same share index is yielding 8.5 per cent, and the bond rate is down to 5.3 per cent, pushing the risk premium on the sharemarket up significantly, to 3.2 percentage points.
On the same measure Wall Street's share investing risk premium has moved from 3.4 percentage points to 5 percentage points, and even higher insurance has been taken out in Europe. The risk premium there was already big at 4.3 percentage points in September. Today it is 6.3 percentage points, as lower share prices push the euro market's share earnings yield up to 9 per cent, and as a flight to the safety of German government debt pushes its long-term government bond yield to 2.67 per cent - a level that is not only below anything seen during the global financial crisis, but the lowest seen since World War II.
That's a fat cushion by historical standards. It's worth noting that even as the markets have melted, some indicators have been pointing in the other direction.
- There are concerns that Europe's growth will be strangled by debt,
- concern too about China's decision to restrict bank lending and slow the pace of its recovery, but global indicators in recent months have in the main been positive.
- Thursday night's slight rise in US jobless claims was an exception, albeit a badly timed one for the markets.
While there's been a spike in a prominent sharemarket fear indicator, the Chicago Board Options Exchange's Vix index, interbank lending spreads are much narrower than they were during the financial crisis.
Yesterday's Australian market bounce showed that some investors see signs such as these as evidence that this is a crisis in name only, and see the elevated risk premiums as a buying signal.
Others will note that the markets remain hostage to political events - none more so than Australia's.
Last night, for example, Angela Merkel's coalition government was preparing to push Germany's share of the €750 billion rescue package for Greece and other debt-burdened European Union nations through its lower house. The vote was going to be close and the markets needed Merkel to win to hold their nerve.
Australia is running into an election that is shaping up as the most crucial for the markets here in decades. Tony Abbott's declarations that a Coalition government would call off the national broadband project that threatens Telstra's hegemony, scrap a tax that penalises highly profitable miners and rewards marginal ones, and find money elsewhere in part by cancelling the Rudd government's planned cut in company tax from 30 per cent to 28 per cent mean that Australian businesses and the markets face vastly different outcomes from a poll that is only months away.
mmaiden@theage.com.au
Source: The Age
http://www.brisbanetimes.com.au/business/its-a-risky-business-dont-you-forget-it-20100521-w1tw.html
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