There was a time, not so long ago, when it had become hard to imagine that investing in the sovereign debt of rich countries could be a risky business.
The 2008 financial crisis should have changed all that, when sovereign debt burdens in the industrialized world exploded as nations rushed to backstop their financial sectors after years of unchecked profligacy. Yet many still clung defiantly to the belief that investing in bonds backed by developed world sovereigns remained the safest bet long term.
But today, as investors weigh up the implications of a dramatically worsening eurozone crisis, faltering austerity measures in the UK and a US sovereign ratings downgrade, they find themselves in uncharted territory. Some say the very foundations of modern finance are under threat – and the implications for how global investors and policymakers think about financial markets are profound.
A growing number of experts argue that the world has changed so substantially since the financial crisis that traditional thinking about risk is no longer relevant. And as the sovereign crisis across the developed world deepens, the very concept of a ‘risk-free’ asset – a benchmark, traditionally US Treasury yields, against which other assets can be measured – is being increasingly called into question.
“If you’re a classically trained economist, you’re likely to be pretty terrified by the absence of a risk-free rate, because the capital asset pricing model is priced off the risk-free rate. In its absence, asset pricing models don’t make sense,” says James Montier, a member of the asset allocation committee at investment management firm GMO, and author of several books on behavioural finance.
Montier says that relative value – or the pricing of an asset relative to any other for investment portfolios – is no longer a meaningful concept, and those that rely on quantitative models to determine asset pricing should ditch such old ways of thinking. “We can’t price anything relative to anything else anymore, if we ever even could,” he says. “Instead, we need to stop and think about each asset class and its price in its own right.”
Asset managers and investors have long considered the US Treasury yield to be the risk-free benchmark for measuring the riskiness of other assets. When ratings agency Standard & Poor’s cut the rating on US credit in August from AAA to AA+, the very concept of a risk-free rate was thrown into sharp relief.
IT’S ALL RELATIVE
But in the wake of the downgrade, the asset class hardly lost its appeal as a safe haven, and fearful investors continued to pile into Treasuries; 10-year US Treasury yields actually dropped by 30–40 basis points, with bond prices hitting multi-year highs. The reason, many argue, is simple: US capital markets are still the deepest and most liquid anywhere – and the dollar remains the world’s reserve currency.
“The only thing that caught the market off guard was the timing,” says Bob Browne, chief investment officer for Northern Trust. “The US downgrade did not change the credit quality of the US bond market. The slow and steady deterioration of the US from a classical credit perspective was well documented.”
But if the US downgrade didn’t matter, and if US government securities continue to be the safe haven of choice, then risk free might simply have become a relative concept.
Citigroup chief economist Willem Buiter has argued it’s just a matter of time before other AAA-rated western sovereigns lose their status. The downgrading of the US, he wrote in an August 9 research note, was a largely symbolic event, which was “both inevitable and overdue”. It brought to an end the post-World War II era in which “for a number of advanced industrial and post-industrial countries, the sovereign automatically represented the best credit risk in its jurisdiction, and an AAA rating for these sovereigns was considered natural – almost a right.”
The downgrade “also represents another step on the road to the complete disestablishment of the G7 as guardians of fiscal responsibility and sustainability”.
“For portfolio allocation, relative risk will be the driver now that ‘risk free’ is no longer an option,” Buiter says.
For fund managers struggling with the notion of risk in their asset allocation decisions, relative safety might still be the guiding principle for investment. But they will have to learn to work in a world without risk-free assets.
FINANCE 101
For Jerome Booth, head of research at Ashmore Investment Management, the problem goes back to basic assumptions in finance theory. “We’ve got an intellectual failure in finance theory, and it starts with the word ‘risk,’” he says. “Risk is a much broader concept than how we commonly use it. It certainly isn’t about volatility or uncertainty, and it’s not binary, in the sense that you have ‘risk-free’ investments.”
Booth says that the fund management industry still spends too much time looking at past data, instead of gearing up for big structural macroeconomic shifts. “You have to have a bigger picture, you have to do some strategic thinking if you want to understand risks. You have a whole industry that doesn’t look at macroeconomics, but this is now a massive problem,” he says.
But it’s not just economic shifts that are in question. Pippa Malmgren, president of the Canonbury Group and Principalis Asset Management, has argued that investors have simply forgotten about the “peace dividend” that had been in place for the last 25 years, since the fall of the Berlin Wall. Speaking at the Chartered Financial Analysts (CFA) Institute Annual Conference, she urged investors to take seriously the fact that the return of political – as well as policy – risk will impact the global investment landscape.
Fund managers say policy risk is already having a serious impact on investment strategy. Political dysfunction – as exemplified by the brinksmanship of both Democrats and Republicans in US Congress over raising the country’s debt ceiling – is no longer solely the preserve of developing countries with typically weak institutions. Managers say they are increasingly worried about the ideological biases of policymaking in the West, which complicates the picture for investment.
“The problem that we all have is that we aren’t sure how to hedge these markets, because we are uncertain about the political risk,” says Neil Dwayne, CIO in Europe for Allianz Global Investors.
Dwayne cites the unpredictability of major policy decisions – especially during a period of economic crisis: “You can have a view on your assessment of political risk, but then find that some of the policy decisions happen on the weekend. It means you can go home with a portfolio that you really like on Friday, and on Monday morning the game has changed, and you can have the wrong portfolio,” he says.
The bottom line is that neither economic nor political stability in the West can be taken for granted any longer. “Developed governments may well abandon questionable austerity measures and default,” says David Bailey, director of PAAC, a consultancy specializing in asset allocation. “With rigged exchange rates, protectionism is always a possibility, and indeed wars are possible, either of which would certainly end supercharged growth for some time.”
The Bank for International Settlements’ (BIS) projection for public debt burdens 30 years from now puts the UK’s debt-to-GDP ratio at over 500%; for the US, it hit 450% by 2040. Towers Watson, an investment consultancy, estimates the interest burden of this debt would exceed 25% and 20% of GDP for the two countries, or about 100% of the revenue the countries would expect to raise through taxation. “We clearly will not get to this point, which means the issue is: what will give, and when,” says the firm in a recent report.
Alan Brown, CIO of Schroder Investment Management, notes that outright default is not the only option for over-indebted sovereigns and that advanced economies can renege on their obligations by stealth too. “You can make a case to say that the US defaulted twice in the last century, by coming off the gold standard, which was a broken promise, and in the 1970s, when we went through a decade of negative interest rates. It’s a breach of trust when you allow interest rates to be below inflation.”
For Brown, G7 government debt today represents a highly inflated bubble. “The private-sector credit crisis has rolled into a sovereign one. Some of the big [countries] will likely face difficulties. It is not clear that Japan can continue to borrow 1% forever when it’s debt to GDP is close to 200%.”
EMERGING WORLD
As another downturn looms for advanced economies, investors have been looking to emerging markets for hope, given their relatively stronger economic fundamentals. Whereas overall debt to aggregate GDP for advance economies is expected to rise from 46% in 2007 to 70% in 2011, and a further 80% in 2016, the corresponding ratios for emerging market economies are 28%, 26%, and 21%, respectively, according to Eswar Prasad, an economist at Cornell University.
“Emerging markets have sufficient fiscal power to be able to stimulate their growth to offset some of the headwinds coming from America and Europe,” says Allianz’s Dwayne. “But we need a carefully thought-through package of policies that would promote sustainable growth.”
Booth says institutional portfolios should increase allocation to emerging market assets. “Maybe a fifth of pensions today and 85% of global central bank reserves are in emerging markets. These are the countries with growth,” he says. “What they do and how their central banks behave is crucial to what’s going to happen. You can’t ignore the structure of the investor base, not if you want to incorporate a real picture of the world.”
But not everyone sees it that way: “Emerging markets may have better demographic trends, and nominal and real growth, but they don’t have the political flexibility to adjust to a crisis,” says Northern Trust’s Browne. “We’ve seen that in the Middle East. Look what happens when things break: it’s a completely new regime change for politics and for society.”
A series of interest rate hikes across major emerging economies over the past year is likely to slow growth, while inflation across high-growth economies remains a major concern. But emerging market policymakers in many cases have the advantage of crisis experience. “If you’re in a dark alley at night, you’d much rather be with the person who has been in a few scraps than with the preppy boy,” says Booth. “I’ve been in meetings where the Brazilians and Koreans are explaining to G7 members how they should be regulating.”
A MATTER OF PERCEPTION
Yet risk perception is as much of a problem for investment professionals as risk itself. Investor behaviour can influence asset value in significant ways, and assets that should be risk-free in a portfolio could turn out not to be.
“The fact that US bond yields fell immediately after the S&P downgrade makes logical sense – people think that policymakers will now be forced to work together to fix things,” says Andrew Drake, managing director at investment advisers P-Solve in London. “Perception is extremely important. Just look at Lehman Brothers. It went from being a massive giant to a complete basket case in a matter of weeks. Money is a confidence game.”
“The stock market can be a great predictor of recessions, but is this because a falling market can make them happen? Markets get nervous about recessions, and stock prices start to fall, so people feel poorer and spend less, reducing growth... it’s a self-fulfilling prophecy.”
This may be widely recognized intuitively, but it doesn’t make it any easier to refine investment strategies or to make policies.
The upshot for Booth is that investors must take the big picture into account in their portfolio decisions. “Unless you get all the macro stuff, you’re missing the risk. We have to fundamentally rethink what risk is,” he says. “The risk we care about is not volatility: it is the big systemic problems, like the depressions, the losses that can never be recovered.”
What’s clear is that the dust has barely settled on a new investment order, just as the global financial system faces another potentially major upheaval. If asset allocation was a tough business before, it’s about to get a lot harder.