Monday, 29 March 2010

How Risk Got Turned Upside Down...

In my Money Week column this week, I've been discussing how accepted ideas of financial risk are getting turned upside down. Here's a taster....

Every investor who has ever filled in one of those seemingly pointless ‘know your customer’ forms churned out by the bank or their stockbroker will be familiar with the way they have to tick a box describing their appetite for risk as high, low or medium.
We all think we know roughly what it means. Say you are low risk, and you’ll be offered some bank deposits, occasionally spiced up with a few gilts. But describe yourself as high-risk, and you’ll be offered a diet of Vietnamese software companies, Nigerian bonds, and Kazak yak hide futures.
That, however, is based on a spectrum of risk that is accepted right across the financial markets. At one end, there is a set of ‘safe’ investments: developed market equities, government debt, the dollar. At the other, there is all the flaky stuff: emerging markets, corporate bonds, commodities. How investors perceive and classify those different types of assets determines how money gets allocated around the world, and how much is charged for it. As a rough rule of thumb, the ‘safe’ assets get lots of money cheaply. The risky ones, much less, and have to pay more for it.
But what if that gets turned upside down? There is a good case to be made that everything the markets have traditionally thought about risk is about to become redundant. The flaky stuff has started to feel secure. The solid assets are looking a bit flimsy.
Let’s start with equities. Plenty of analysts have started to argue that the emerging markets are a lot safer right now than the traditional developed bourses. “While many Developed Markets are witnessing rapidly rising public debt, large fiscal deficits and slower growth, most top-tier Emerging Markets weathered the global crisis much better in terms of public-debt sustainability and the short to medium-term growth outlook,” argued Deutsche Bank in a research note this month.
Indeed so. The developing countries of Asia, Eastern Europe and Latin American look in far better shape than the old industrial giants of Europe and North America. Their economies are growing a lot faster. With the exception of Russia and parts of Eastern Europe, they have far better demographics. And they are in much better fiscal shape.
Of course, there are caveats. They have shallow and sometimes untrustworthy capital markets. They don’t have much in the way of experience. Nobody is sure if they trust the legal systems. Those are all reasons to be cautious. Still, it is looking increasingly odd to regard India as high-risk compared to Spain, or to view Vietnam as dodgier than Greece. On balance, there is a compelling argument that what’s risky has been turned upside down. Indeed, investors appear to have already recognised that, piling into the emerging markets far more enthusiastically than Europe or the US.
The same could soon happen to bonds. Government securities have always been regarded as safe, compared with corporate bonds. And the bigger and richer the country issuing them, the ‘safer’ they are rated.
But does that really make sense any more? Governments have run up massive debts, and show little sign of recognising the need to bring them back under control. Plenty of people are now reckoning in the prospect of default, either blatantly, or covertly through letting inflation rip. It’s certainly possible. Beyond about 100% of GDP it becomes virtually impossible for a government to pay off its debts either through growth or higher taxes, and plenty of governments are getting close to that. Some are way past it.
So who would you rather lend money to, BP or the British Government? One has tons of oil in the ground, and decades of experience of refining and distributing it. The other has a mass of liabilities, a spendthrift government, and a stagnant economy that is already taxed up to and beyond its ability to pay. In reality, corporate bonds may very soon look like a safer bet than government bonds.
How about currencies? The dollar has, for decades, been reckoned to be the most rock steady of safe assets, the ultimate haven. It was closely followed by the euro and the yen. And whilst those are all big currencies, backed by massive economies, it’s hard to believe they will be ‘safe’ over the next decade. The dollar and the yen suffer from massive fiscal deficits. With the growth of new economic powers, they will inevitably dwindle in importance. It is hard to see other currencies taking the place – not, at least, unless the Chinese decide to up the status of the yuan. But commodities could easily replace them. Gold would be the most obvious candidate. But oil could do the job just as well, or else a basket of industrial minerals.
The important point is that in every area of the markets, old ideas about risk are being turned upside down. That has two important implications.
The first is that is will change the price of everything. The riskier the investment, the higher the premium usually demanded to put money into it. So once your risk assessment changes, it follows the price of everything changes as well. Emerging markets will become more expensive than developed ones, corporate bonds pricier than government debt, and so on. As an investor, you don’t want to get caught on the wrong side of that shift.
Next, the flow of money changes as well. Traditionally, more money goes to the ‘safe’ assets, less to the ‘risky’ ones. So that is going to change as well. Everything we used to regard as risky will be drowning in cash. All the old ‘safe’ assets will be desperately short of it.
Once that trend gets established, it may well be unstoppable. And, by 2020, if you tick that box describing yourself as risk averse, you should expect your broker to offer you some Indonesian equities, some telecom bonds, and some oil futures – with, possibly, a few high-risk German government bonds or American equities thrown into the mix just to spice it up a bit.

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