Tuesday, July 8, 2014

Chart Mania: "Good news: risk aversion is declining"

From Calafia Beach Pundit:
This post is an updated and somewhat expanded version of one I made last December. I think it was insightful then, and the major themes still hold today. Importantly, however, things look a little better now than they did just seven months ago, mainly because there are growing signs that risk aversion is beginning to decline.

The recovery from the Great Recession of 2008-09 has been the weakest ever, and that has a lot to do with the fact that this has also been the most risk-averse recovery ever. Households have deleveraged like never before; the world has stocked up on cash and cash equivalents like never before; banks have accumulated trillions of dollars of excess reserves; and business investment has been exceptionally weak despite record-setting profits. Contrary to popular perception, these facts suggest that the real function and purpose of the Fed's Quantitative Easing program was to satisfy the world's voracious appetite for risk-free, safe assets, which in turn was a by-product of the scariest recession ever. The reason QE has not boosted the economy is because QE has only served to treat the symptoms of risk aversion that have held the economy back. With QE now winding down, and risk aversion beginning to decline, the economy is facing reduced headwinds and growth could therefore begin to pick up.

Why so much risk aversion? There are undoubtedly lots of reasons, but the obvious ones are 1) the profound shock that accompanied the Great Recession, as the global economy and financial markets teetered on the brink of disaster; 2) the great uncertainty that has accompanied the Fed's unprecedented foray into Quantitative Easing (you can see that uncertainty reflected in the surge in the price of gold to $1900/oz.); 3) the increased regulatory burdens imposed by Dodd-Frank and Obamacare; and 4) the trillion-dollar deficits that arose from a massive increase in government spending in 2008 and 2009.

Many of these problems are still with us, but they are fading. The federal deficit has plunged by fully two-thirds, to only $490 billion in the 12 months ending last May. The Fed is tapering QE and should finish within a matter of months. Obamacare is slowly but surely imploding, and market-based reforms are the only viable and sensible solution. Global equity market capitalization has reached new highs, and this surely reflects at least a decline in pessimism if not the return of some optimism. Swap spreads in most major markets are at very low levels, suggesting an almost complete absence of systemic risk. PE ratios are now at above-average levels. As risk aversion declines, risk taking increases, and that is an essential ingredient for healthier economic growth....MUCH MORE
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...MUCH MORE