How risky are risky assets?

- TOWER


Overall, the consensus view is that:
•    The global economic recovery theme remains on track with leading indicators generally continuing to improve.
•    The authorities are maintaining accommodative policy and will do “whatever it takes” to ensure stability and allow “time to heal”.

Indeed, key data for investors such as unemployment (i.e. relevant to the consumer and final demand) and housing (the root cause of all the problems) has steadily improved, August included.

But investors are extraordinarily nervous that risky assets have risen “too far too fast” and that a correction is overdue and even required, despite credit markets being only marginally higher and equity markets being well below levels of a year ago. There seems to be no shortage of commentators describing markets as overbought, although it is often not clear relative to what.

The bare case rests on expectations that, with business unlikely to be investing strongly for some time and government stimulus potentially fading, it is difficult to see final demand picking up and that surely this is what a sustained global recovery requires. In addition, the argument goes that while the write-off risk of “toxic assets” may now be manageable, that doesn’t mean that equity positions are sufficient to accommodate an increase in write-offs from what were previously regarded as non-toxic assets (hence, the apparent reluctance of banks to materially increase activity).

The real problems facing investors appear to be gauging the momentum of the recovery and simply, price. It may well be that economic data continues to show improvement and even surprises on the upside but after the magnitude of the rally since early March, the obvious risk is that much of the recovery has been priced and any disappointment will be severely punished.

Part of the bull case for risky assets is that investors have no choice but to move up the risk curve as investors can’t buy a coffee off the yield from less risky assets such as cash and “quality” bonds and therefore, investors have little choice but to embrace riskier assets. An interesting observation here is that should there be disappointment over the pace of recovery, rates will stay lower for even longer, which again will ultimately push investors into riskier assets. The last part of the bullish theme is the contention that many investors have missed the rally in riskier assets (credit and equity) by remaining in cash and that those investors will “capitulate” and put that cash to work.

The obvious issue with the bullish theme is price. Presumably, the more risky assets rally, the lower the long-term expected return becomes and eventually valuation issues will catch up (imagine getting caught twice!).