How risk aversion could threaten the global economy
We don't always agree with Morgan Stanley's Stephen Roach - but his opinions are certainly worth listening to. Widespread falls across all asset classes show that investors are rapidly losing their appetite for risk. Is there any reason for this - or does it just prove that bubbles are perfectly capable of bursting under their own weight? And if so, which asset classes are most vulnerable?
There can be no mistaking the power of the risk reduction trade that has just occurred. It is on a par with the big reversals of the past.
What is particularly interesting is that this outbreak of risk aversion has occurred in the absence of a financial crisis and in the absence of a major shift in the underlying fundamentals of the global economy.
The tentative conclusion is that this episode is more about the markets than anything else - and the fear that the liquidity goose that hatched the golden egg is about to take flight.
A couple of years ago, our foreign exchange strategy group constructed a proprietary measure of the appetite for risk embedded in world financial markets.
The MS Global Risk Demand Index is both cross-border and multi-asset in scope. It is designed to measure the movements in a variety of risky assets relative to their riskless counterparts. It includes comparisons between emerging-market and developed-market bonds, base metals versus precious metals, cyclical versus non-cyclical equities, equities versus bonds, volatility in equities, bonds, and FX markets, and credit market and swap spreads. Some ten sub-indices are constructed daily and geometrically weighted to create the aggregate GDRI.
The index has been back-tested to 1995 and has a good record in capturing the big moves in risk appetite clustered around the major financial crises of the past decade - including the Asian crisis of 1997, the Russian debt crisis of 1998, the bursting of the Nasdaq bubble in 2000, the 9/11 terrorist attacks of 2001, and the deflation scare of 2003.
It is more descriptive than predictive, but can certainly signal important flash points at either end of the risk spectrum.
Recent trends in the GRDI underscore the significance of the latest risk-reduction trade. In late May, the risk-appetite metric moved to extremes last seen during the deflation scare of 2003. At work was a widening of spreads in a number of segments of the risk universe - especially emerging-market debt and base metals - together with a long-overdue rebound in market-based measures of volatility.
A widening of credit and swap spreads also contributed to this move. For those who claim that asset bubbles cannot be identified until after the fact, this dramatic move in the GRDI provides compelling ex-post confirmation of a bursting of a bubble in risky assets. On a daily basis, the GRDI hit a low on Monday 22 May, and has since retraced more than half its plunge into negative territory.
It's hard to know from the empirical history of the GRDI if this latest move signals an end to the risk reduction trade. The extremes of recent fluctuations in the index typically trace out multi-bottom shifts in risk appetite; the only single-event episode over the past decade was the risk reduction move that coincided with the deflation scare of 2003.
The current risk-reduction episode is quite different from those of the recent past in one very important respect - it was not sparked by a discrete, event-driven crisis.
Sure, there has been an inflation scare, but it's hardly a serious one; the most credible of the worst-case prognoses only sees underlying inflation moving up to a 3% rate in the developed world over the next couple of years.
At the same time, there has also been a growth scare - prompted by fears of a Fed overshoot. This presumes that the US central bank might fall victim to its seemingly classic tendency to overdo monetary tightening and push the US economy into recession.
But here, as well, the fears are hardly extreme - especially with Ben Bernanke going out of his way to telegraph the likelihood of a pause in the Fed's tightening campaign, even if cyclical risks have not abated.
Finally, there has also been a currency scare, as fears of a dollar crisis were evident briefly in the immediate aftermath of the 22 April G-7 meeting. However, while the yen and the euro have both moved up in response, the post-G-7 increases have been measured - about 3% for both currencies versus the dollar. If anything, with the stewards of globalisation now on the same page in facing up to the imperatives of global rebalancing, there is a more compelling case for an orderly adjustment in currency markets.
By process of elimination, that points the finger at the markets themselves. In my view, this is all traceable to the excesses of a super-liquidity cycle - aided and abetted by inflation-targeting central banks that have paid minimal attention to pressures building in asset markets.
Ironically, the road to price stability has been more perilous than the authorities envisioned. By ushering in an era of single-digit returns on financial assets at precisely the point when the demographic imperatives of retirement planning require higher returns, the resulting asset-liability mismatch has forced investors much further out on the risk curve than might otherwise have been the case.
That tendency was exacerbated by two additional developments - an unusually cheap cost of 'carry' (i.e., short-term funding costs) set by overly-accommodative central banks and a growing tendency toward herding by momentum-driven investors.
This has resulted in the now-infamous multi-bubble syndrome, as yield-hungry investors have swarmed into one high-yielding asset after another.
First equities, then bonds, then spread products (emerging market and credit instruments), then property, and most recently commodities - the excesses of the super-liquidity cycle have created bubble after bubble. The tight correlation of bubble-like blow-offs in a broad array of risky assets may well be the ultimate manifestation of this liquidity-driven mania.
By its very nature, the concept of the bubble lulls investors into a false sense of security. It's an image that conjures up the proverbial 'prick of the pin' that then leads to an abrupt and worrisome deflation of a market that has gone to excess. Absent the 'pin' - normally thought to be an interest rate spike - investors have no fear of bubbles.
Yet, this imagery is actually quite misleading. Yale Professor Robert Shiller has long stressed the tendency of asset bubbles to implode under their own weight (see Irrational Exuberance, second edition, 2005). In other words, it doesn't always take that unpredictable 'bolt from the blue' to send overvalued assets crashing back down to earth.
To stretch the image a bit further, if the weakest portion of the bubble's membrane fails, damage can quickly spread to the rest of the asset class. Think back to the US equity bubble of 2000. Dotcoms were the weak link in that chain - not the overall equity market. Yet when the dotcom bubble burst in March of that year, the resulting carnage was sufficient to take the entire S&P 500 down by 49% over the next 2 1/2 years. Contagion within an asset class - and across asset classes - is a classic symptom of a liquidity-induced multi-bubble climate. That, in my view, is precisely the risk today.
Our internal debate over this possibility has been quite intense. By Joachim Fels' reckoning, the global liquidity cycle has already turned. He reaches this conclusion based on his analysis of both the quantity and the price of liquidity.
While I can hardly fault Joachim's logic, I am less convinced that our metrics are robust enough to render a precise verdict on the timing of any shifts in global liquidity. In particular, while I believe central banks are headed in that direction, I am reluctant to conclude that they have done enough to stem the torrent. The Fed's policy stance is hovering somewhere in the proximity of neutrality, but that is not the case for the other important central banks in the world - namely the European Central Bank, the Bank of Japan, and the People's Bank of China. This latter group of authorities has, at best, only just begun the long march toward policy neutrality.
It is in the world's best interest to manage the endgame of the risk reduction trade very carefully. But there are no guarantees the authorities can pull it off without a hitch. The steady build-up of global imbalances and multiple asset bubbles is very much part of the same problem - a US-centric world that is riding one of the most powerful liquidity waves in history.
My newfound optimism on global rebalancing stems mainly from the outcome of the G-7 and IMF meetings of April 22 - meetings that gave me hope that global policy authorities have finally come to the joint realization that an unbalanced world can no longer afford to stay its current course.
Yet in the end, the only way to change that course is to break the liquidity-induced addiction that has fed an increasingly dangerous profusion of asset bubbles. That will take nothing short of determined and courageous efforts on the part of politically independent central banks. I am encouraged that the authorities are now collectively leaning in this direction for the first time in over 15 years. Yet I am mindful of the risk that the burden of proof is on them. The risk is I may be guilty of putting too much faith in the now-constructive rhetoric of the so-called stewards of globalization.
I am also mindful of the fact that there is still likely to be considerable breakage on the road to global rebalancing - irrespective of determined efforts on the part of the authorities to avoid that outcome. I would interpret the recent risk reduction trade in that context. Like it or not, the multi-bubble syndrome has become so advanced that liquidity-fueled investors squeezed long-standing risk premia out of some of the world's riskiest asset classes.
As Shiller stresses, there are plausible stories behind each of these assets - emerging market debt and equities, high-yield bonds, and even commodities - that speak of the proverbial 'new era' that rationalises a re-rating of risk.
And yet the time-honored pitfalls of liquidity-driven markets are perfectly capable of triggering amplification mechanisms that can put an unrealistic - and ultimately unsustainable - price on these stories. The violent reversal in our proprietary risk index challenges the validity of the 'new era' interpretation of these moves and provides support for the alternative notion that prices of risky assets had moved into bubble-like territory.
The risk reduction trade may well be capturing the downside of the benign strain of global rebalancing. Just as there are perfectly plausible stories that explain the willingness of investors to abandon historical risk parameters, there are equally plausible stories as to why the dismissal of that risk makes little sense.
For emerging markets, a likely reduction of excess consumption in the US spells potentially tough adjustments for these still externally-dependent economies. For credit markets, a similar adjustment is quite possible - especially if an unbalanced world loses support from the most powerful engine on the demand side of the macro equation.
And commodity markets could be equally vulnerable. They appear to have been pricing in open-ended support from China at just the time when the Chinese are signaling the move to more of a 'commodity-light' growth dynamic - less exports and investment and more consumption.
The power of the recent risk reduction trade, as validated by our proprietary GRDI metric, is a strong reaction to bubble-like excesses in the prices of these highly correlated risky assets. Global rebalancing - even the benign strain I now favour - tells me that these trades probably have a good deal further to go.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum