TIME TO TAKE SOME CHIPS OFF THE TABLE / THE FINANCIAL TIMES COMMENT & ANALYSIS

Markets Insight

June 16, 2014 6:03 am

Time to take some chips off the table

By Mohamed El-Erian

Revival of ‘goldilocks’ story encourages levering risk exposures

Investors have rekindled their romance with the “Great Moderation”, and fallen back in love with “goldilocks”.

These two terms are among the most powerful in the markets lexicon. They encourage many investors to stretch and stretch again for extra returns by levering exposures to a broad range of risk factors. Yet what appears both a reasonable and rational strategy at the individual level, given current conditions, threatens a disruptive fallacy of composition at the macro level down the road.

The terms last featured prominently in 2005-07 when the belief spread that policy makers had succeeded in overcoming the business cycle, thus leading to low economic and market volatility – at least for a while. The result was excessive and irresponsible risk-taking.

Their recent reappearance, while less dramatic, is due to two factors: an economy that is improving slowly but in a rangebound fashion, with little prospect of either a collapse or lift off; and a Federal Reserve that is transparent, measured and supportive of asset markets.

Investors have taken these two factors as signalling a predictable and extended period of economic, financial and policy calm. And should this calm be threatened by some unanticipated development, such as a geopolitical shock, they have been conditioned repeatedly to expect the Fed to step in and restore it quite promptly.

Risk exposure

This environment is one that naturally encourages investors to use borrowed money to increase their exposure to risk factors, particularly in the more liquid public markets. In the process, they continuously compress the risk premiums and, therefore, the reward for taking ever greater exposure. Yet, with the promise of more tranquillity ahead, they will “ride the market” until there is an unambiguous signal of a “turn”.

This phenomenon is amplified by a few rigidities. Investors are loath to reduce their return expectations even though initial investment valuations have moved significantly higher. The cost of applying the brakes too soon is increased by capital allocators who can be sensitive to short-term performance.

Meanwhile, many investors are comforted when they are part of a herd, even if it is one that ends up going to excess. And few investment banks are willing to take large positions on the other side given that shareholders seem to have less patience for shortfalls in trading revenue, no matter how short term.

The behaviour of most financial investors stands in contrast to that of companies and some central bankers.

Many companies are still hesitant to invest in plants and equipment notwithstanding cash on their balance sheets and low-cost borrowing opportunities. They know they do not have their financial counterparts’ ability to unwind their risk exposures and thus engage only tentatively in substantial long-term commitments.


Market instability

For its part, the Fed is comforted by continued signs of labour market slack, including in this month’s jobs report. Yet more central bankers (including US regional Fed presidents Narayana Kocherlakota and Eric Ronsengren, and former Fed governor Jeremy Stein) are recognising that current Fed policy may result in “signs of financial market instability”.

With a rather anaemic economy, the central bank is willing to trade higher financial instability down the road for greater economic healing in the present; and it believes (or more accurately hopes) that the recent strengthening in macroprudential regulation will prove sufficient to limit such financial instability should it materialise.

All this suggests that, rather than continuously increasing exposure to ever rising markets, it is time for highly exposed investors to gradually take some chips off the table.

They also need to monitor the liquidity of portfolios carefully, as it makes less and less sense to give up their flexibility to reposition for what is a low reward for assuming large liquidity risks. And, in taking long positions in markets, they should guard against falling hostage to a “relative” valuation mindset that overwhelms any assessments of the overall compensation for risk.

In their efforts to promote growth and jobs, central banks are trading the possibility of immediate economic gains for a growing risk of financial instability later. This does not necessarily mean investors should rush for the exits, immediately and in size. But it does call for the type of incremental prudence that today’s marketplace appears overly hesitant to adopt given the recent evolution of market prices.


Mohamed El-Erian is chief economic adviser to Allianz, chair of President Barack Obama’s Global Development Council, and author of “When Markets Collide”

Copyright The Financial Times Limited 2014.