FYI | May 26 2006
By Greg Peel
Yesterday brought news that Credit Suisse’s Global Risk Appetite Index had crashed out of the "euphoria" zone with the biggest fall in market sentiment since the crash of ’87. While the long term macro trend is disinflationary, CS fears a short term rise in core inflation will push bond yields higher and affect a shift away from risky assets (such as resources and emerging markets).
Merrill Lynch’s own measure of risk appetite works off different inputs, and is focused on credit availability. In fact it is also flipped as it measures "risk aversion". Risk aversion most recently peaked in 2001 (tech crash), when credit was very tight, and steadily fell to 2003, when credit became readily available. It remained low until March before turning northward again.
Those who have chased risk through to this point have been rewarded. Those who began to reduce risk exposure in the early months of this year have now been vindicated as well, as extreme volatility is risk incarnate. The next step should be an explosion in risk premiums and a tightening of credit. However US indicators suggest otherwise.
Merrills notes the Fed has reported credit remains freely available in the June quarter 2006. This suggests to the analysts that a slowdown in the US, and globally, through to 2007 will be reasonably benign. What we will see, says Merrills, is a "transition period" akin to 1995-97 which encourages tactical and opportunity investment rather than a robust structural theme.
Merrills believes the risk run is now behind us as central banks seek to tighten interest rates, leaving more risky assets looking overvalued. The analysts advise a move towards a more balanced portfolio (risk reduction) featuring core assets with steady earnings growth. Bond markets in which central banks are most advanced should gain support, the analysts suggest.