Financial market operators and leading investment funds in several countries are now betting on two major trends in world markets: increasing risk of loss or low asset performance, and increasing distrust of many types or classes of assets. This latter trend includes lower confidence in global equities performance, a retreat of funds from several leading commodities including oil and even gold, and a possible rapid fall in confidence regarding government bonds and debt. One measure of this is a trend towards bets that stock price volatility will increase, before equity markets fall and perhaps crash, and rising numbers of put options on Treasuries, German government bonds and the Japanese yen at their current levels, and for government paper their present unrealistic low yields or interest rates.
This points to a much more dangerous environment, especially for "mainstream" equity investors, but also for government and corporate bond market investors: either the bond market will make the big move, or the equity markets will make the big move because of rising instability and falling visibility for the global economy.
Nassim Taleb, whose book “The Black Swan” is prescient on the role of unforeseen and under-appreciated events causing markets to panic, said he believes not only US bond markets, but also those in Europe and Japan could "collapse", but this will not mean that investors should shift to equities. The underlying and basic reason, he believes, is that investors have not understood or do not want to accept that the global economic recovery is faltering. This has driven yields on two-year US Treasury notes as well as German 30-year and 10-year bonds to record lows last week, and the yen to record highs in recent weeks, but is not at all sustainable.
Stocks in August had their worst month since May, and US index futures tend to drop at easily predicted intervals as economic reports indicate the recovery is flagging. Moves by US Fed chairman Ben Bernanke, at the Jackson Hole meeting of central bank chiefs, to reassure investors have been weak and unconvincing while the ECB's Jean-Claude Trichet has painted a picture of European economic recovery that many judge exaggerated. In the same way the yen has continued strengthening against the dollar, the Swiss franc has strengthened to a record against the euro.
Asset correlation
As Nassim Taleb and others have noted, one major new danger is the convergence and correlation of so many, apparently different and unrelated assets whose total volume and nominal value has massively increased and globalised since the 1990s. Both oil and gold are good examples. Despite their commodity status, at least for oil, their price movement is now increasingly correlated with general equities movement – except in special circumstances. Almost any day major equity indexes like the DJIA, Footsie, Dax or Nikkei move up, the oil price will also rise; if the equity indexes fall, oil will also fall – and despite the previous non-correlation or low correlation of gold price movement with equity prices, this now also tends to apply with gold.
Asset correlation now extends to most other asset classes, including currencies and government paper, forming what we can call a kind of "undifferentiated global asset space".
As a general rule, when assets are highly correlated risks are much greater, and when volatility also increases the potential for radical and rapid decline of asset values is raised. Almost all experts agree the financial system is now much riskier than it was before the 2008 crisis which triggered the US economy's worst contraction since the Great Depression. In turn this would certainly make a "double dip" relapse in the US economy, or in Europe and Japan far worse than the previous recession.
As we know, and as Bernanke and Trichet have many times pointed out, governments have injected huge amounts into the economy. US President Obama’s American Recovery and Reinvestment Act has spent $814 billion trying to spur growth, and this effort has helped raise US public debt to $13.4 trillion, according to official data. In Europe, the sovereign national debt crisis, and the extreme high public debt of most European countries, is very well known – and continues.
Uncorrelated assets
Despite many real world factors which make this uncertain, asset managers believe that growth in China and India is "decoupled" with the OECD economy. Both countries have engaged financial and economic “big bang” reforms giving foreign investors greater access to their capital markets. Their buying of gold and commodities starting with oil, are now basic drivers of price movements for gold and oil.
It is possible but not sure that further shifts of global funds into their markets can help maintain China's and India's strong economic growth and yield good returns for foreign investors. Downstream from this, certain commodities like uranium, coal and iron ore, copper and fertilizers may weather the storm upstream, in OECD financial markets. Where equities are tight-linked with one of the better performing "hard assets" these, too, should be favoured.
The search for uncorrelated and less risky assets is now a prime driver for asset managers and will be intensified by polarising investor sentiment. More selective and closer managed holdings are now favoured, across the asset space and around the world. In coming months, if the shakeout on OECD equity and government bond markets, and the return to a declining US dollar continues, we can expect to see major moves in the relatively few asset types or classes that can perform.
Email the writer:
a.McKillop@alrroya.com
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