The Return of Risk

Source: Danske Bank

* Over the past few weeks, risk aversion has increased on financial markets driven by the fear of deteriorating credit quality, primarily in the US mortgage market. We believe the recent turmoil is a market correction and not a prelude to a major meltdown on financial markets

* Panic in credit markets rarely lasts long, unless it is driven by macro-fundamentals. Corporate financing requirements are still too low to generate any longer-term significant widening of credit spreads. The net resulting tightening of credit should be manageable for the global economy as economic fundamentals are unusually strong and global monetary policy is broadly neutral.

* That said, the ongoing tightening of global monetary policy should eventually lead to a normalisation of the pricing of risk. It seems likely that the current events are the first steps in this normalisation and a full-blown return to the goldilocks situation of the last few years with extremely high returns and low volatility will be difficult.

* While event risk is here to stay, and financial market turmoil could continue for some more weeks, we believe that on a three- and a twelve-month horizon our financial forecasts will not be significantly affected. We expect further monetary tightening in Europe and Japan, higher global bond yields, and a narrowing of credit spreads. Furthermore we see a continuation of funding/carry trades on FX markets, moderate but positive returns on equity markets, and we expect emerging markets to remain strong.


Turmoil across the board

Credit markets have been the main driver of the development on financial markets lately as risk aversion has increased and liquidity in the credit market has plummeted due to fear of deteriorating credit quality in especially the US mortgage market. The tighter liquidity and increased risk aversion is increasingly spilling over into prices of risky assets classes in financial markets like carry currencies and emerging markets.

We believe global economic fundamentals are currently strong. That said, we also believe that the pricing of risk on a number of financial assets has not been fully appreciated by the markets over recent years. See for instance our research paper series "Awash With Cash" starting January 2005, where we analysed the effect easy liquidity conditions have on financial markets in terms of creating an environment of tightening credit spreads, falling volatility across markets, a low probability of financial distress, low bankruptcy rates, too low long bond yields and expensive assets on a global scale.

Over the past year we have seen a couple of market corrections, where risk aversion in financial markets suddenly rose (see for instance Awash With Cash 6: "A Wake up Call", where we argued that the turmoil in May last year could be the beginning of the end to easy money). These corrections have been temporary, and the central question is if the current turmoil is just another market correction. If this is the case markets will return to their previous paths, as markets are calmed by continued strong performance of the global economy, and liquidity will gradually return to the credit market.

Or is the current turmoil in credit markets an early warning sign of deteriorating economic fundamentals? If this is the case, financial markets could ultimately accelerate through financial instability and into a major credit crunch. This would be the end of easy money and favourable trends on financial markets.

The answers to these questions depend on:

* How will the housing market and ultimately the US economy perform on the back on tighter mortgage lending following the surge in losses on sub-prime mortgage lending?

* Is there a danger of a global corporate credit crunch as corporate bond spreads have widened and some banks are being forced to put committed debt on their own books when liquidity in the credit market has disappeared?

* Is there any risk of a systemic meltdown in the financial sector, with an important player collapsing because of excessive exposure to risky assets?

Below we try to answer these questions and we evaluate the implications for the different parts of the financial markets.


Conclusions

Our main conclusion is that this is a market correction and not the prelude to a major meltdown on financial markets. This conclusion is mainly based on:

* Global economic fundamentals remain strong and we believe the problems in the US subprime sector will remain contained although the weakness on the housing market is deeper than expected.

* It is far too early to talk about a global corporate credit crunch with real impact on corporate capital expenditure. The increase in credit spreads in an historical comparison has been modest, and monetary policy on a global scale cannot be considered tight. There is still plenty of liquidity in the global economy. Further, corporate balance sheets and cash-flow remain strong.

* As of yet there are no signs of major systemic risks in the financial sector. The increase in interbank swap-rates (risk-premium in the interbank-market has been modest), and the estimated default probability remain close to historical lows.

On the other hand, we believe it would be wrong to conclude that nothing has changed. The rating agencies have changed their opinion on some risky asset classes. Volatility in different markets has picked up, equity markets are worried, and carry/funding trades on FX markets have been affected. Overall we believe that some of the recent risk repricing is of a more permanent nature.

At a more general level, this should be taken as a first sign that we are witnessing the beginning of a shift in the overall risk assessment in financial markets, which can take quite some time before it is completed. Our belief is that this process will not be steady or smooth. In the coming months, markets could easily return to the state of "goldilocks", where risk will be as low as it has been over the past few years. However, the bottomline is that the normalisation we are seeing globally of monetary policy might eventually lead to a normalisation of risk. Focus, credit quality, stock picking, and more normal conditions are likely to gain importance in the near future. It will become more important to differentiate risk on fundamentals.

Furthermore, we believe this market correction will be somewhat prolonged and will take its lead from credit markets hopefully returning to some kind of normality in the next three months. While event risk will remain high, especially in the very short run, we do not expect these events to have any major implications for monetary policy. We still expect Bank of Japan and the ECB to raise rates in August and September, respectively. We also expect long bond yields to increase. Funding currencies like JPY and CHF will weaken, and carry currencies like AUD and NZD will strengthen. Corporate bond spreads are likely to narrow somewhat, and emerging markets will continue to be strong.