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Evolving Risk Appetite
From FNB
18 July 2006
A good fright usually gives rise to an adrenalin surge. If false alarm, the shock takes time to wear off (for the extra adrenalin to disperse). Instead of being ready for flight or fight, the body can stand down.
Something like that happened to global financial markets during May-June. Shock, false alarm, stand down.
There was enormous shock to the senses: "oh my gosh, inflation is loose, the central banks are going to murder the world economy, easy liquidity is evaporating, exposed assets gonna fail". Scary stuff.
This turned out to be false alarm (at least to date). The world economy could still get murdered (geopolitical and oil shock), but that's another and possible future story. What matters is the here and now.
Yes, global inflation pressure has risen modestly, with enduring fast growth over 4%. Yes, leading central banks are determined to be less generous, raising interest rates to more normal real levels, taking away excessive liquidity, wanting global financial markets to be less on steroids and contributing less to financial imbalances and inflation pressure.
When cycle-ends come into view, and central banks make their will felt, the old adage is "don't fight the Fed".
Central banks will always be stronger in enforcing discipline than what markets can continue partying. What applies to parents and teenagers, applies in spades to the world of finance. Pull the plug. Party over. Be gone.
But nobody appears determined to murder anything, despite earlier loose talk of willingness to commit growth sacrifice. Inflation is only modestly adrift. Inflation expectations remain well anchored, not least because of central banks' credibility.
The party had been going a long time (four years), exuberantly in emerging equities and commodities (tripling of asset prices becoming standard fare). There had been few checks and only encouragement from central banks (in providing excessive liquidity and then timidly starting draining it). Markets had kind of forgotten the nature of the angry parent when pushing the limit.
And these teenagers had pushed the limit.
Global carry-trade speculation and commodity prices pushed to enormous heights (not all for fundamental reasons) complicated the inflation picture. Global growth so good it started up the inflation bogey.
Along with deepening global trade and capital flow imbalances (not the markets' doing) it all finally riled central banks, like parents being pushed to the limit after a particularly trying evening.
"Okay, somebody's going to get shot if this doesn't end NOW". Guaranteed to frighten teenagers, if they aren't too stoned. Markets certainly were, and the boys and girls out in the emerging periphery were the last to understand that a death threat had been made back nearer the parental source of rage in New York (it not helping one little bit that the new stepfather sounded rather incoherent, as if fearful to face the wrath of the partygoers, not an unnatural cowardice when first facing unfriendly fire).
"You want to do WHAT? End the party? WHY? Out of your socks, professor?" And more such unprintable stuff.
Anyway, it is all history now. He merely wanted the music turned down, the bar closed, the go-go girls back in their clothes, and the wilder elements on their way home, so that those who wanted to reminisce late into the night could do so peacefully, while he could go to bed, safe in the knowledge that everything was nailed down.
Remarkable, how fathers can simmer down when on top and in control again. Perhaps they remember their own youth.
So that is where we find ourselves today. The first shock was major. The more risky assets were sold off, as panic stations decided whether to fight or flee.
It then turned out that growth was slowing in parts, but not precipitously, and certainly not globally. Indeed, healthy rotation is underway (US slowing, others faster). Inflation pressure was gradually mounting, but would be peaking soon. Inflation expectations remained contained. No asset class went belly up, not even the most exposed.
Doesn't mean to say these dying ambers can't still catch fire anew. And the whole parental show of anger would have to be repeated (and the shock wave).
But it needn't happen (unless oil catches us shortly). Although central banks will keep raising rates through yearend, financial markets are standing down. Risk appetite is returning. The old frog doesn't look such a bad Hun after all.
Nonetheless, caution dictates preference for less risky emerging countries with current account surpluses and select commodity producers (Canada, Aussie).
Suspicion lingers about deficit countries. Even so, worst offenders (Hungary and neighbours) may be too small to start contagion.
The problem children are stabilizing, if oversold, but improving risk tolerance may have to wait for the end of the global tightening cycle (next year).
South Africa's Rand faces weakness at 7.00-8.00:$. Its equity market may experience more volatility, especially if the SARB pushes rates somewhat higher.
Now, if only new shocks could stay in abeyance. But isn't the Middle East again catching fire?
Original articles published at www.fnb.co.za.
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