Friday, 29 January 2010

Waking up to a new reality

This is beginning to look like something we have seen before. Stock markets are falling in a straight line. Yield spreads – the difference between government bonds and corporate/mortgage bonds – are widening. Sovereign spreads – the difference in yield between bonds issued by virtuous states (read: Germany) and reckless states (read: Greece, Spain, Portugal, Dubai) are moving the same way.

VIX, the index for S&P volatility, had fallen in a straight line since the panic in October 2008. With the recent setback, VIX has moved up visibly, indicating nervousness in the stock market. After months of overperforming, emerging markets are now leading the stock markets downwards.

Adding all of this together paint a picture of a market where risk aversion is increasing. Investors want to be better paid to take on risk.

We last saw this in early 2007 (and we all know how it continued), when there were good, solid reasons for the financial markets getting jittery.

This time around the situation is quite different. The economies are recovering, corporate earnings are heading north and beating expectations easily. Interest rates are low and liquidity is more than abundant. The stock markets are not by any measures expensive. Ben Bernanke has even been confirmed for his second term in office and the weather is beautiful in Davos.

So we cannot really use the economic background as an explanation. Instead I believe that the best explanation is found in the theme I addressed last week, general versus specific risk aversion.

Since 2007 risk pricing has moved in two long trends: First pricing of risk went through the roof and then, as the central banks opened the liquidity spigots, risk pricing fell dramatically. By some measures it even fell to prices lower than seen any time since 2005.

In other words, since 2007, the fears of a systemic meltdown and the attempts to stave it off have been the major drivers of risk aversion. Now that the economy is improving and the central banks are signalling that they will eventually adjust the monetary policy to a more normal situation.

The financial markets are coming off their life support and that will have a lot of practical implications. The tide will not lift all boats as it was the case through 2009 and we will be on our way back to a situation where we have to estimate the risk related to each individual investment.

The current trouble in Greece is a good example. The yield spread on Greek sovereign debt has risen in line with the market's appreciation of the risk. But as the story broke, the first reaction was to price all the other southern European countries as if they had the same problems. They may also have problems, but those problems are not the same as those of the neighbours.

This analogy is probably also true for the stock markets where even badly managed companies have gained strongly in value during the relief rally. This is unlikely to continue going forward. We will all have to go back to work and get used to the fact that risk is not only a macro factor.

Why should this mean that the markets go in reverse? For the simple reason that it represents a change in the dynamics compared to what we have seen in the past two years or so. And the markets have shown beyond any reasonable doubt that they are very bad at handling changing dynamics.

No comments: