Where is the risk in global financial markets?

UK Weekly, Jul 13, 2007

* Risk spreads and financial market volatility have declined significantly in recent years, but the evidence suggests that these benign financial market conditions are linked mostly to cyclical rather than structural factors - notably strong world growth and high corporate profitability. Markets appear to have projected this positive cyclical picture into the indefinite future, resulting in prices for risky assets that offer little insurance against even a moderate worsening in financial market conditions.

* A prolonged period of low long-term interest rates may have led to the mispricing of risky assets. An upward correction in long-term rates would probably have a modest negative impact on global growth, but the bigger risk looks to be that higher long-term rates could trigger large corrections in a number of markets which look overvalued.

* One risky area is the LBO market - LBO financing is now higher as a proportion of GDP than its previous peak in the 1980s, leverage ratios are rising and activity looks vulnerable to tighter global liquidity.

* In the corporate debt market, issuance has risen sharply in recent years, but more worrying is the evidence of a deterioration in credit quality within issuance. The share of the lowest-rated entities in overall issuance has risen significantly and, against this background, current extremely low default rates cannot be expected to persist. In the syndicated loan market, the weight of subinvestment grade issuance is even higher, above 50%.

* The weakening US housing sector has already had a significant negative impact on US GDP growth, and the worst may already be over. We doubt significant negative wealth effects will materialise, but we are concerned about a wider economic impact from problems in the subprime mortgage market. Rising delinquencies have already led to a sharp weakening in credit default swaps on the lowest-rated subprime-based asset backed securities and there is a risk this distress could spark a broader sell-off in the structured products sector.

* Much attention has recently focused on the possibility that hedge funds post a systemic risk to the global financial system, but we think these concerns may be overdone. Hedge funds already have a high attrition rate, and there is limited evidence that they are crowded into high-risk trades.

* A large correction in the risky markets we have identified could have a significant impact on global GDP growth, because structured products and LBOs have been key elements in the rapid recent growth of financial sector activity. The impact would likely be significant in the US and especially the UK, given the importance of the financial sector in these countries' economies. Growth could be pushed to below-potential levels in both countries

Risk spreads and volatility have declined why?

Over the last few years there has been a remarkable period of spread compression in global financial markets, and also a notable drop in volatility across asset classes, encompassing bonds, equities, money markets, and foreign exchange. There are a variety of possible explanations for this, one of which is that the fall in volatility reflects a drop in macroeconomic volatility - a development which may have been assisted by improved conduct of monetary policy. This explanation is not entirely convincing, however while macroeconomic volatility in the G7 has edged down recently, the big drop occurred in the late 1980s. Macro volatility also remains above the levels seen in the late 1990s - a period when financial market volatility was notably higher than today.

Another possible 'structural factor' leading to lower market volatility may have been financial innovation via an increased supply of hedging and risk transfer instruments like options and credit default swaps. In our view however there is strong evidence to suggest that developments in volatility and spreads have a cyclical rather than structural root. The VIX equity volatility index has tracked movements in corporate profitability relatively well over the last twenty years, albeit with a number of 'spikes' associated with major credit events. The last period when VIX volatility was at today's low levels, in the mid-1990s, was a period of strongly rising corporate profitability, and the drop in VIX volatility since 2003 has been even more closely associated with the surge in corporate profitability that began then.

A further factor that may have contributed to recent benign financial market conditions is the relative absence of major credit shocks. From 1997-2002 there was a series of major shocks which disturbed markets, including the Asian and Russian crises, 9/11, the US recession, the Argentine default and the second Gulf War. Since 2004, markets have had to contend with a surge in oil prices and terrorist incidents, but these have been insufficient to offset the positive impulses from sustained global growth and rising corporate profitability.

In our view, there is evidence that suggests that markets have been projecting current low levels of volatility - and high liquidity - into the indefinite future, a risky thing to do if cyclical factors are indeed behind current benign market conditions. The result of this has been a rapid growth in the supply of and demand for risky assets, at prices which have offered little insurance against even a moderate worsening in financial market conditions.