Pragmatic Capitalism

Capital for Living a More Practical Life


By David Schawel, CFA, Economic Musings

It’s only natural that investors begin to pause after such a strong rally in risk assets (in less than 3 months), and reassess whether it makes sense to stay long risk.  No need to rehash why we have rallied as it’s been a confluence of factors worldwide including better than expected US economic data and a easing of stress in the euro zone.  Nonetheless, JP Morgan addressed this very issue this weekend in an excellent “Q&A”.  Here is an excerpt:

1.The fundamentals are no good. The world economy is at 2%, barely growing, with Europe already back in recession, profit margins peaking, and a decade of fiscal austerity holding back the private sector. –– Agreed that the macroeconomic fundamentals are not enticing. But the financial fundamentals of high risk premia versus falling uncertainty are compellingly attractive and truly at the core of what defines asset price value.

 2.The rally is just a house of cards built on easy money. When the liquidity music is over, the asset price bubble will deflate and give it all back. –– High risk premia on equities and credit are indeed due to the near-zero yield on cash and safe government bonds, not because equity and corporate bonds are themselves that attractive. But that is how monetary stimulus works. And central banks will not take back this stimulus until the economies and markets can stand on their own feet, which is several years from now. Remember the old adage of “Don’t fight the Fed”. Surely one should not do so when the Fed works in concord with all other central banks in the world.

• 3. Every one is long now. –– Speculative positions in futures and by macro hedge funds clearly show they are aggressively long risk now. At our Paris Conference last week, 2/3rds of our audience said they were long risky assets. But overall leverage by hedge funds remains subdued, and asset allocators have only shallow longs. Retail investors continue to pour more money into safer bonds funds than equities or high yield. The world as a whole has higher than average cash holdings and some 70% of world holdings offer no positive yield after taxes and inflation.

• What trigger is left to push up risk markets to the next level? –– Accepted there is no obvious trigger as there was before EMU Summits or the Greek restructuring. And our economic growth forecasts are in line with consensus. But within our line of thinking, the true surprise, and thus trigger, is no surprises. High risk premia mean the market is priced for risks and thus negative surprises. If these risks, ill-defined as they may be, do not show up, then that is by itself an event that surprises relative to market pricing.

• There remain tons of risks in front of us. The US and Euro governments have simply kicked the can down the road, China is weakening dramati- cally, and Israel will not wait forever. –– Yes, monetary easing and fiscal stopgaps have simply bought time, but time is what is needed to heal wounds. US fiscal decisions will have to await the elections while Europe has a lot of work to do to put together its fiscal compact. The US Administration will want to exhaust all diplomatic tools before making a military decision on Iran, if it ever will. The markets thus face a lull in event risk over coming months, even as long-term uncertainties remain.

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