RISKY
BUSINESS A sea-change in risk
perception By Jephraim P
Gundzik
Overly loose monetary policy in
the US and Japan has masked rising global
investment risk. This tidal wave of cheap dollars
and yen encouraged investors to ignore age-old
risks associated with soaring credit growth.
Plunging stock markets around the world
and dollar depreciation indicate that risk
perceptions are changing dramatically. This change
in risk perception will produce a prolonged and
sharp
correction in all of the
world's stock markets. Growing risk aversion will
push US Treasury yields lower, triggering dollar
devaluation and soaring precious-metals prices in
the months ahead.
Blame the Fed and the
BOJ In an attempt to deflect imported
deflation from Japan, the US Federal Reserve under
Alan Greenspan began to loosen monetary policy in
early 2001. After the terrorist attacks on New
York City and the Pentagon in September 2001, the
Greenspan Fed pushed interest rates aggressively
lower to support the US economy and financial
system. Though the economy began to recover in
2002, the Fed maintained its aggressive easing
through 2004, pushing US interest rates to a
50-year low.
The Fed reversed course in
late 2004, but the very slow pace of
monetary-policy tightening did little to weaken
thriving mortgage-credit growth, which continued
to bound higher in 2005. The combination of
super-loose monetary policy and very gradual
monetary-policy tightening encouraged mortgage
lenders in the US greatly to loosen credit
standards, triggering unprecedented growth in US
real-estate values and home construction.
The booming housing market accelerated US
economic growth, further obscuring investment risk
associated with very rapid credit growth and
sharply deteriorating credit standards.
The Bank of Japan (BOJ) followed the Fed's
example throughout the early 2000s, leaving
nominal interest rates at 0%. Monetary policy in
Japan was further loosened after the BOJ
implemented its quantitative easing policy, which
flooded the financial system with cash in the hope
of reviving domestic credit growth and private
demand. Rapidly changing demographics in Japan
muted the impact of the BOJ's free-money policy.
This forced the BOJ to prolong this policy, which
remains largely in place.
Though the BOJ
had trouble boosting private demand at home, its
free-money policy began to flow through the
financial system, which became an intermediary for
external yen borrowing. This external borrowing,
more commonly known as the yen carry trade,
lavished trillions of yen on foreign banks,
brokers, insurance companies and investors who
subsequently invested in much higher-yielding
assets, especially in emerging-market countries.
The limitless supply of ultra-cheap yen
from the BOJ greatly obscured investment risk not
only in Japan but wherever the yen carry trade was
used by investors to boost returns. Because the
yen carry trade was employed in stock, bond and
real-estate markets around the world, the BOJ in
effect muted global investment risk, pushing asset
values to massively overvalued levels relative to
risk.
Risk exists after
all Though monetary policy in the US and
Japan remains extremely loose, the sudden
downdraft in global equity markets and dollar
depreciation, which began early this month,
indicate that risk perceptions have changed
dramatically. This sudden shift was driven by
unexpected weakness in the US economy - the
product of the collapsing housing market, soaring
real-estate foreclosures, and their very negative
impact on the US financial system.
Investors around the world ignored
excruciatingly obvious indications, which first
appeared in early 2006, that the US housing market
was rapidly weakening. Investors also failed to
understand the negative implications this weakness
held for global economic growth and asset values.
While the Fed and the BOJ are to blame for
obscuring investment risk, the perpetuation of
this masquerade has been greatly abetted by the
world's largest investment banks and brokerages.
These institutions, with their exceedingly
optimistic global economic outlooks, also
encouraged investors to ignore investment risk
associated with super-fast credit growth. The time
has come to pay the piper. Banks, brokerages and
investors will pay a huge price over the next
several months for ignoring rising investment risk
over the past several years. Unlike the mid-2006
mild correction in global asset values and the
dollar, the current correction promises to be
exceedingly brutal.
The 2006
mini-correction was driven by fear that monetary
policy in the US and Japan would tighten
significantly. The Fed and the BOJ quickly allayed
these fears by keeping monetary policy overly
loose. This led to a rebound in asset values and
dollar appreciation against the yen as investors
redoubled their yen-carry-trade positions.
In contrast, the current correction is
being driven by the closing gap between US
economic reality and perceptions spun by banks and
brokers promising a "Goldilocks" recovery. As the
reality of rapidly slowing US economic growth and
spreading problems in the financial system
overtakes investors, the overvalued US equity
market will continue its downward trek, falling
another 20% at least. To be sure, the gathering US
economic recession will force the Fed to loosen
monetary policy further. However, this will do
little to arrest the decline of the economy or the
stock market.
Though interest rates will
fall in the US, this will not immediately
stimulate a resurgence in the housing market.
Mortgage lenders and banks saddled with growing
non-performing loan portfolios will continue to
tighten credit standards, leaving many potential
borrowers in the cold. At the same time, surging
foreclosures will add to the housing supply,
forcing home prices much lower. This loss of home
equity combined with a credit drought will
undercut private demand in the US, prompting a
rise in unemployment and further weakness in
private demand.
A 20% correction in US
stocks will push stock markets around the world
lower. However, emerging-market equity and bond
prices are likely to plunge much more deeply. The
yen carry trade has pushed hundreds of billions of
dollars into emerging-market assets over the past
two years, though investment risk in many
countries has increased exponentially. Economic
recession and falling interest rates in the US
could prove to be the dollar's death knell,
forcing sustained unwinding of the yen carry
trade.
Dollar weakness will greatly
benefit precious metals, especially gold, in 2007.
Falling US interest rates will also benefit
precious metals, particularly if rising commodity
prices continue to push global inflation higher.
The pendulum has begun to swing away from risk
predilection toward risk aversion. Fasten your
seatbelts, because this swing is gaining momentum.
Jephraim P Gundzik is president
of Condor Advisers. Condor Advisers provides
investment risk analysis to individuals and
institutions worldwide. Visit
www.condoradvisers.com for more information.
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