Hoping to Re-Risk after De- Risk? A Global Dilemma

Posted in Finance Articles, Total Reads: 1505 , Published on 31 March 2014

Every Business and Every Product has risks. You can’t get around it – Lee Iaccoca.

The global PMI index was clearly touching 60 till the early 2007, the investor community up till at that point was in a state of euphoria. Between the period late 2007 till late 2010, the PMI index was below consistently below 50, the lowest being 36 at one point and the period after 2010 has clearly remained above 50 though it still has to touch highs of pre-2007 era. After 3 years of stagnated growth, the business activity coupled with the increase in consumer confidence has signaled a ray of hope among the investor community who for two years (2007-2009) were sandwiched between precious metals and US securities. The rise in business confidence as well as consumer confidence globally clearly indicates an increased appetite in risk taking. The movement in Risk appetite index as measured by state street investor confidence index clearly indicates that the investor confidence is in upswing mood after lows of 80 in the years 2007, 2008 and a brief state of panic in the year 2012.

Image Courtesy: freedigitalphotos.net, pakorn

To lend credence to the fact that the macroeconomic conditions globally are improving, the above GDP percentage change of major countries shows that period after 2009 has shown marked improvement but yet to reach highs of pre-2007 era. The hope the world currently harbors is based on improved economic data. However, we should not be blinded by the improvement in the above mentioned economic parameters as risk is a two way lane. Though the above mentioned signs indicate that the hard landing of world economy predicated by Eurozone break up, US massive fiscal deficit, war between Israel and Iran are now difficult to justify than they were a year and half ago. However, the unconventional monetary policy of quantitative easing of US. Abenomics in Japan which has met little success in pulling Japan out of two decades of stagflation and deflation, continued recession in Eurozone despite support from Central banks which had resorted to Long term Refinancing operations (LTRO) has only delayed the consequences of excessive leverage which these countries had built up.

The emerging markets of China where growth has slowed down from 10%, India whose GDP growth is being put at around 5%, Russia, Brazil and Singapore are still at 3% shows that even the emerging markets are unable to shrug off the slowdown. The pre 2007 rally in commodities, equities was fuelled by an appetite for greed and excessive liquidity across the world. Post 2007 world saw asset re-allocation from commodities, equities (particularly riskier assets of emerging markets) to government bonds (US) and precious metals. Though the performance of global financial markets has increased considerably, the failure of central governments especially European countries to reduce GDP to debt ratios to manageable proportion without increasing consumption, slowing industrial activity and higher levels of unemployment might push them into the category of emerging markets. The expectation of new emerging market countries is not without evidence.

Apart from India and Australia (only marginally), most of the countries in the figure above have debt to GDP ratios of more than 100% and in terms of unemployment rates China and Euro Area tops the charts. Though the world has witnessed improved global activity in terms of industrial production and consumption pattern the downside risk of weak domestic consumption in emerging markets remain. The capital inflows in the emerging markets have been volatile mainly reacting to the news of quantitative easing (QE) exit by US. The sudden increase in capital inflows (sometimes also called “Hot Money”) led to depreciation of currencies leading to expensive imports but made the increased demand of their exports (J-Curve theory). But sudden outflow/reversal of capital highlighted their dependence on foreign currency to drive growth and investment. This sudden reversal has led to inflation in the prices of emerging market assets. This correction is highly believed to be related to the pace of the withdrawal of US QE policy which in turn will depend on the job data of US, inflation and US growth. However, to put the onerous task of supporting the world economy on the shoulders of US would be suicidal. The liquidity enhancement monetary policies of banks in Europe, China and Japan should be timed well so as to support the weak economic growth in their countries and prevent further bailouts. The deleveraging of the world economy is currently underway however; the policy of zero rates needs to be done away with to further accelerate the process. The massive liquidity raised the prices of assets whether temporary or permanent remains to be seen but the global investors have entered a turbulent and uncertain phase where the markets have begun de-risking but risk aversion seems to hold sway over their asset allocation and only time will tell whether re-risking will ever take place.

This article has been authored by Mudit Gupta from Credit Suisse (ODA Payroll)


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