Quarter 3 2011 investment markets review
Risk-free return to return-free risk
Students of finance will be aware the so-called 'risk-free' rate
is a fundamental building block for the calculations used to value
assets and is at the core of many economic models. It is the
compass for financial markets and a concept that has successfully
guided investors and financiers for more than two
generations. In August, the most widely used benchmark to
define the risk-free rate - namely the return from US Treasuries -
was called into question as one of the world's leading rating
agencies, Standard & Poor's, cut the long-term US rating one
notch from AAA to AA+. The agency stated the outlook for the
creditworthiness of the US was negative and cited concerns about
its budget deficit.
The loss of this precious AAA-rating was, in theory, very
important for market participants. Standard & Poor's had
delivered a headline-grabbing message that there had been an
increase in the risk - albeit tiny - that the US may one day renege
on its financial obligations. In normal market conditions, yields
would have been expected to rise to reflect this increased risk and
meet the return expectations of investors taking on this extra
risk. As we know, we are currently in the middle of very abnormal
market conditions and we have actually seen yields fall. Rather
ironically, US debt has been seen as a safe haven given the sharp
deterioration in the global economic outlook we have witnessed
during the second half of the summer. The increasingly chaotic
European sovereign debt markets further elevated the attractiveness
of Treasuries as a safe haven, but the yield on the 10-year
benchmark bond fell to 1.92% as at the end of the quarter. At these
current elevated levels, Treasuries, along with UK gilts and German
bunds, are offering negative real returns and highlight the erosion
in wealth investors face as the imbalances created by the
profligacy of governments and their respective societies, over the
last decade, is slowly reversed. The shift from a risk-free return
to return-free risk is a stark reality and has major implications
for Western societies as a whole, particularly as the baby-boomer
generation heads towards retirement.
This story aside, returning to the key shaping forces that have
placed downward price pressure on risk assets - namely the European
funding crisis and the worries surrounding the economic growth
prospects in the US - this has been an eventful quarter. Christine
Lagarde, the new managing director of the International Monetary
Fund (IMF), voiced a collective sentiment when she warned the world
economy found itself in a 'dangerous new phase'. Economic newsflow
has undoubtedly been disappointing and analysts, including those
working for the major central banks, have been forced to downgrade
forecasts for the rest of the year and 2012. The mood of investors
has been further darkened by fears the circuit-breakers put in
place by the European authorities, to control the risk of contagion
in the event of a sovereign default, may be found wanting,
particularly as the yields on bonds issued by Italy and Spain rose
sharply this quarter.
Our quarterly commentary in July made reference to the
uninspiring political leadership so far shown in Europe and the US
and this remains a key risk as we move towards the final quarter of
the year. The European banking system is under severe stress
and the window of opportunity to present a credible solution to the
sovereign funding crisis appears to be closing fast. Without this,
the capital adequacy of systemically important banks will continue
to be questioned given the likelihood of a disorderly sovereign
default. The European authorities have been slow to recognise the
rising contagion through the financial system and the European
Central Bank (ECB) has until very recently denied banks are in need
of large-scale recapitalisation.
Other factors which shaped the performance of risk assets through
the third quarter included the grim US economic newsflow regarding
the labour market, housing and manufacturing, all of which combined
to create a sharp sell-off in both domestic equities and those
listed on bourses around the world. The US fiasco of the debt
ceiling debate highlighted the widening polarisation in views.
Extremist economic policies are receiving media attention including
calls from the Tea Party for 'the abolishment of the Federal
Reserve because of its quantitative easing policies' (source: BCA
Research).
Keeping with the Federal Reserve, its chairman, Ben Bernanke,
and his colleagues on the Federal Open Market Committee met over 20
and 21 September. Markets were looking for clues as to what the
central bank's next move might be in his speech delivered at the
recent Jackson Hole symposium. As to be expected, Bernanke was
positive on the long-term outlook for the US economy stating 'the
growth fundamentals of the United States do not appear to have been
permanently altered by the shocks of the past four years'. He did
not, however, say anything new about the near- term outlook nor
highlight any additional policy moves. There is a general
market-wide acceptance the Fed's options are limited, so what
better plan than to poke the finger of blame for their plight at
Europe and tell them to get their house in order. It
certainly served as a temporary respite and took the heat off the
US, but it refocused the markets attention on Europe's political
indecision and the quarter ended with markets once more plummeting
as the reality dawned - nothing much has changed and there is still
far too much debt in the system than can realistically be
absorbed. Default looms large.
This, perhaps more than any other single event, weighed heavy on
markets as they ended the quarter with the FTSE 100 and the S&P
500 both losing 14%. This was broadly in line with equities
globally which fell 15% as measured by the MSCI All Countries World
Index. Europe was at the epicentre of declines with the German DAX
suffering one of its largest single day declines in 10 years, and
the European DJ Stoxx closing down 23% at the quarter end.