Economist.com Page 1 of 3 Fin a n cia l m a r k e t s A qu e st ion of pe r spe ct ive Mar 18t h 2004 From The Econom ist print edit ion Th e ou t look b r ig h t e n s f or g ov e r n m e n t b on d s a n d d a r k e n s f or r isk ie r a sse t s TO NO one's sur pr ise, Am er ica's Feder al Reser v e left shor t - t er m int er est r at es at a 46- year low of 1% on Mar ch 16t h, again w it h heav y hint s t hat t hey w ould st ay t her e a w hile. Per haps, indeed, for longer t han m any had t hought : out put , pr ev iously descr ibed as “ ex panding br isk ly ” is now m er ely gr ow ing “ at a solid pace ” ; and t he Fed gav e a nod t o t he w eak j obs m ar k et t hat it had not giv en befor e. Som e econom ist s now t hink t hat r at es w ill not be r aised unt il t he m iddle of next year. Ult r a- low int er est r at es pose a huge pr oblem for inv est or s and ult im at ely for t he Fed it self. The cent r al bank 's st ance has encour aged punt er s t o t ak e r isk s on an unpr ecedent ed scale. Am er ica's r ock - bot t om int er est r at es hav e unleashed a flood of m oney int o r isk y asset s t he w or ld ov er . Since lat e 2002 ev er y t hing fr om r ich- count r y shar es t o em er ging- m ar k et bonds hav e soar ed as Am er ican inv est or s, w ho sav e alm ost not hing, hav e sought bet t er r et ur ns t han t he desult or y ones av ailable fr om popping t heir m oney in t he bank . The num ber s ar e st r ik ing. Bet w een t he st ar t of 2003 and it s peak on Mar ch 9t h, Japan's Topix st ock m ar k et index r ose by 35% , all because of for eign buy ing: dom est ic inv est or s sold all t he w ay up. At it s high point in Febr uar y Am er ica's S&P 500 w as m or e t han 30% up; NASDAQ, dr iv en by hope and hy pe, clim bed m or e t han 60% by lat e Januar y befor e t ak ing a br eat her . Ev en Eur opean shar es w ent up by 20% or so in a bit m or e t han a y ear , depending on t he m easur e. Ger m any 's DAX gained m or e t han 40% , despit e t he econom y 's flir t at ion w it h r ecession. The em er ging- m ar k et equit ies capt ur ed http://economist.com/PrinterFriendly.cfm?Story_ID=2523781 25/08/2004 Economist.com Page 2 of 3 in t he w idely w at ched MSCI flew up by 50% last y ear ( see char t 1) . Spr eads of r isk ier bonds ov er r isk less gov er nm ent debt collapsed j ust about ev er y w her e. I n Eur ope an index of liquid eur obonds, com piled by Cr edit Suisse Fir st Bost on, t ight ened against sw aps ( t he r at e at w hich t he best bank s lend t o one anot her ) by 70 basis point s ( bps, or hundr edt hs of a per cent age point ) fr om t heir w idest point , t o 28bps in Januar y. I n Am er ica, t he fir m 's inv est m ent - gr ade cor por at e- bond index shr ank fr om 247bps t o 84bps ov er t he sam e per iod. Junk and em erging - m ar k et bonds had t heir biggest and fast est ev er r ally . Not a single issuer in J.P. Mor gan's EMBI + index of em er ging- m ar k et bonds saw spr eads w iden ( char t 2) . What began as a legit im at e sear ch for higher r et ur ns follow ing a collapse in pr ices in m any m ar k et s led t o v aluat ions t hat st r et ched t he bounds of cr edulit y and m ade lit t le or no allow ance for er r or . No m at t er : ev en at t he st ar t of t his y ear , j ust about ev er y indicat or of r isk appet it e suggest ed t hat inv est or s w er e, if any t hing, m ore gung - ho t han ev er . Flow s int o equit y m ut ual funds in Am er ica in Januar y r eached a size ex ceeded only in t he fir st t w o m ont hs of 2000. The fund m anager s sur v ey ed in Januar y by Mer r ill Ly nch w er e k eener t han t hey had ev er been on shar es, and loat hed w it h equal passion t he m eagr e y ields on gov er nm ent bonds. Their appet it e for r isk has m eant a buoy ant st ar t t o t he y ear for init ial public offer ings aft er a fallow 2003 ( see ar t icle) . Ther e w er e cer t ainly good r easons for t his ent husiasm for equit ies, bey ond low int er est r at es and heady gr ow t h. Pr ofit s, especially in Am er ica, hav e been ex t r aor dinar ily st r ong. Shar e pr ices hav e also been suppor t ed by gr eat er cer t aint y about t hose pr ofit s. A m uch - follow ed m easur e of t his, t he Chicago Boar d Opt ions Ex change's VI X index , w hich m easur es t he v olat ilit y of opt ions on t he S&P 500 , fell by m ore t han half; by t he m iddle of Januar y it w as at lev els last seen in 1996. Bu t w h a t if? I t is a good r ule of t hum b, how ev er , t hat if t hings cannot get any bet t er , t hey can only get w or se. So it has t ur ned out . To gr im new s about lack of j ob gr ow t h in Am er ica has been added gr im m er new s about t he t er r or ist at t ack s in Spain, and sur v ey s suggest ing t hat consum er s in bot h Am er ica and Eur ope ar e st ar t ing t o fr et . So ar e som e econom ist s, w or r ied t hat last y ear 's shar p pick - up in gr ow t h in Am er ica and elsew her e m ight not be sust ainable. Hav ing st ar t ed t he y ear in bullish m ood, inv est or s hav e becom e m or e sk it t ish t oo. I n Mer r ill Ly nch's lat est sur v ey only 48% now ex pect t he global econom y t o st r engt hen t his y ear , com par ed w it h 74% in Januar y . And if it does not ? Then gov er nm ent bonds ar e not as ex pensiv e as m any had t hought , and shar es and cor por at e bonds ar e r at her m or e ex pensiv e—and t he r isk ier t he asset and t he loft ier it s pr ice, t he dear er it w ill look . Thus t he pr ices of Am er ican Tr easur ies hav e soar ed and http://economist.com/PrinterFriendly.cfm?Story_ID=2523781 25/08/2004 Economist.com Page 3 of 3 t heir y ields hav e dr opped. At t he st ar t of t he y ear , t en - y ear Tr easur ies y ielded 4.3% , w hich m ost inv est or s t hought absur dly low . They m ust t hink t oday 's pr ices ev en sillier : r ecent ly t he y ield t um bled below 3.7% . Adm it t edly , t he Tr easur y m ar k et has been giv en a boost by for eign cent r al bank s, not least t he Bank of Japan, w hich hav e been buy ing m asses of Am er ican gov er nm ent debt as a by - pr oduct of huge int er v ent ion in t he cur r ency m ar k et s. Yields hav e also been dr iv en low er by Fr eddie Mac and Fannie Mae, Am er ica's t w o m or t gage giant s, w hich hav e been for ced t o buy Tr easur ies as y ields dr opped, t o r eplace t he m or t gages in t heir por t folios t hat hav e disappear ed as hom eow ner s hav e sw apped t hem for cheaper ones. Many fund m anager s hav e bought out of sim ple fear t hat y ields m ight fall fur t her st ill. But for all t hat , t he low y ields on Tr easur ies cont ain an unpleasant m essage for inv est or s t hat hav e been buy ing w it hout heed t o r isk or price —t hat t her e is m uch uncer t aint y about fut ur e econom ic gr ow t h. That m essage, and it s cor ollar y —t hat r isk is ill r ew ar ded —seem s t o be filt er ing t hr ough at last . Fr om t he m iddle of Januar y , inv est or s st ar t ed t o dum p r isk y , gener ously v alued asset s. The pace has pick ed up in t he past couple of w eek s. St ock m ar k et s hav e been falling: t he S&P 500 is now 5% off it s m id- Januar y high, and NASDAQ has dr opped som e 10% . The VI X has clim bed shar ply , and so hav e bond spr eads —for invest m ent - gr ade cor por at es as w ell as for t he m ost t oxic sor t . St ock s and bonds issued by com panies m ost ex posed t o t he business cy cle and t er r or ism , such as air lines, hav e been har d hit . I nv est or s ar e plagued by doubt s about Det r oit 's Big Thr ee car m ak er s. Spr eads on t heir bonds hav e w idened shar ply , and t hose issued by For d—t he w or ld's biggest issuer of cor por at e debt —hav e far ed v er y poor ly r ecent ly . Against st iff com pet it ion, t he aut o sect or , dow n 17% so far t his y ear , has been one of t he w or st per for m ing in t he S&P 500 . A st or m in a t eacup, or a pr elude of w or se t o com e? By hist or ic m easur es few equit y or cor por at e- bond m ar k et s ar e cheap; m any ar e v er y ex pensiv e indeed. This m ak es it all t he m or e possible t hat a v ir t uous cy cle of r ising gr ow t h and appet it e for r isk can t ur n int o a v icious cy cle of falling gr ow t h and av er sion t o r isk —w hat ev er t he Fed does. 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