What The Current Decline In Risk Aversion Means
Although the military
operation in Iraq is far from over, it would appear that most of the
more serious threats have now been contained and any spillover into other
countries is now unlikely. As a result, much of the risk premium that was
built-in to the financial markets over the past six months has now, to a large
extent, been unwound — lower gold prices, higher Treasury yields, stronger US
dollar, lower energy prices and lower implied vitalities ( the non-intrinsic
value of an option).
Furthermore, it would now appear that investors
are actually venturing back into risk-taking mode, as certain conventional
measures of market risk appetite have started to increase. This is evidenced by
higher emerging market currency values, lower emerging market bond spreads and
micro-cap stocks (up 2% last week) outperforming the overall market in recent
weeks.
What to expect going forward
These developments indicate that the high beta
performance (high correlation) of the markets will start to break down in the
weeks ahead. Gold, oil, and bond prices will start to behave independently, and
not move in the same direction. Similarly, the US dollar and equities will be
less negatively correlated to the previously mentioned instruments. More
specifically for stocks, the equity universe should again become a meritocracy,
where industry or sector plays won’t be as rewarding as individual plays or
pairs trading (relative value).
Investors should also expect higher-yielding
currencies to outperform lower yielding ones (Australian dollar vs. Swiss franc
or Canadian dollar vs. US dollar), as the interest rate returns on the higher
yielding currency will exceed any currency depreciation.