Lesser Risk Asset

Posted By Darren Winters on Feb 1, 2020

Lesser Risk Asset

Finding the lesser risk asset in this frothy financial landscape would be challenging under normal circumstances, but these times are anything but normal.

A decade of emergency monetary policy, which entailed a head-spinning cocktail of negative, or near-zero interest rate policy and an unprecedented amount of liquidity pumped into the financial market through a program known as quantitative easing (QE) has created the bubble of bubbles, the everything bubble.

It is no revelation to say that when the central banks inject liquidity into the market, irrespective of whether they are purchasing bonds with long or short maturities, this will cause asset prices to rise. 

Put simply, if you take a bath and open the tap the water level rises in the tub. 

So QE1, QE2, QE3, Operation Twist, and the latest “not QE4” have aided and abetted hyperinflation in asset prices. 

QE to infinity has also distorted risk which has made spotting the asset with the lesser risk even more tricky

For example, stock and bond prices do not usually rise simultaneously. 

Typically, bonds, fixed-income investments, are the lesser risk asset than stocks. In a risk-off scenario, when investors are cautious bond prices tend to rise and stocks fall.

But in a post QE environment everything rises, the central bank has disconnected risk from the market and that changes investors’ behavior. In a QE to infinity environment, investors perceive risk assets as high returns with minimal or no risk. That then attracts speculative money (hot money) into risk assets because investors perceive high returns with minimal risk. 

Disconnecting risk from the market and tampering with market forces, which drive investors into risk assets has consequences

Lesser risk asset

The Central bank’s QE to infinity is like removing the circuit breaker to “fix” a problem on an electrical circuit. 

It’s a reckless short term fix, it doesn’t address the underlying problem, which was a 2008 subprime crisis of mal investments. Paradoxically, a policy of even greater liquidity pursued by the central banks is canceling risk, and that is likely to result in an even greater crisis, which was what it was intended to fix.

Are stocks a lesser risk asset in a post QE environment, albeit in the short term?

Stocks are overvalued by whatever matrix.

The price-to-earnings (P/E) ratio, a popular measure, shows the stock price at their highest level in recent history with the S&P 500 index SPX, -0.40% trading at 18.6 times forward earnings. That is well above the average P/E ratio of 16.7 during the past five years and 14.9 over the past ten, according to FactSet data.

So the S&P 500 index is now even more overvalued than ever, well above its dotcom bubble peak.  

Market price to sales ratio, another matrix to value stock prices, is now higher than the dotcom bubble. Moreover, the price-to-earnings (P/E) ratio, a popular measure.

Bonds, typically the lesser risk asset are frothy too

Global sales of new corporate debt across all currencies have reached the equivalent of $2.44 trillion in 2019, already a new annual record. A few market watchers are waving a red flag that the corporate debt binge could burn investors

With historic low cash deposit interest rates and massive central bank buying of bonds which have driven bond prices to sky high and their corresponding yields lower even conservative investors are swimming in the deep end desperate for yields. 

The number of bonds carrying negative yields increased to an all-time peak of $13.2 trillion in August 2019 in the wake of a dramatic rally in bond markets around the world

Even Junk bonds, high-risk debt is overbought in a market drunk on liquidity and disconnected from risk. Moreover, sovereign debt is not the lesser risk asset of fixed income assets. 

Jamie Dimon says financial markets’ only bubble is in sovereign debt.

But from the above information, I disagree with Jamie Dimon. The corporate bond bubble, particularly in the energy sector is the mother of a bubble. 

The only part of Jamie Dimon’s statement made at the World Economic Forum in Davos, Switzerland that makes sense follows. 

“Right now people think central banks around the world can do whatever they want. They can’t,” the bank CEO told CNBC, adding that inflation “would be the big negative surprise,” said Jamie Dimon.

Is cash the lesser risk asset, a greater store of value?

Cash is trash, throw it out according to Ray Dalio.

Creating new currency without any increase in productivity will debase the central bank’s fiat currency.

The Turkish Lira, Sri Lankan rupee, Argentina’s peso, Nigeria’s naira, and the Venezuelan Bolivar have all recently experienced a currency crisis due to the mismanagement of monetary and fiscal policy 

So cash can be trash if you are holding the wrong currency. The USD is stable and is still the world’s reserve currency. 

There are also haven currencies to hold in a risk off environment.  

I saw a Swissy rally on the cards back in 2019. Moreover, with the SNB added to the US’s watch list of currency manipulators the Swissy rally could still have legs, particularly in the backdrop of deteriorating financial and geopolitical uncertainties. 

What about brick and mortar, surely real-estate is the lesser risk asset? 

Yes there is a real-estate-bubble too and it is most visible in the high-end real estate which tends to be bought by wealthy buyers with collateral, high income and are considered low credit risk and therefore can take advantage of the low 

Low-middle income households have not seen their properties rise at levels experienced at the high end because post-2008 financial crisis mortgage lenders have been less flexible about who they lend to. 

So investing in the lesser risk asset is particularly challenging in this environment. The classic investment strategy is to diversify your portfolio with assets that are negatively correlated. The idea is that when one part of your portfolio falls heavily the part rallies strong, which mitigates any potential correction. 

But in the bubble of everything when everything rises, all assets have a positive correlation and that is what makes diversification tricky this time.

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