Risk Aversion vs. Risk Taking: What's in Store for 2010?

With 2009 coming to a close, I’d like to take a look back at the role that the big-picture environment has played in determining how currencies, and all financial markets, performed. And how that might change, or stay the same, in 2010.

For 2009, it was all about risk appetite. It was a tug-of-war between risk aversion and risk taking. This dictated what was happening with global currencies, stocks, bonds, commodities … all financial markets. And for most of the year that battle was clearly won by an increasing global appetite for risk.

Here’s how it played out …

After the global financial system was on the brink of collapse in late 2008, it became apparent in early 2009 that disaster had been averted. And when Bernanke announced that he saw “green shoots” in the U.S. economy, it was a green-light for global investors to start dipping their toes back in the water.

Gradually investors started feeling better about the world. And as they felt better, they started taking on more risk. It was a shift in focus, away from the mandate of “return OF capital” back toward one of “return ON capital.”

For global markets this risk-centric investment environment caused a breakdown of historical inter-market relationships and the emergence of a new, and tightly correlated … “risk trade.”

A Recap of the Risk Trade …

In a sense, the risk trade has been easy to understand. The dollar has moved one way and practically everything else — such as currencies, global stocks and global commodities — have moved in the opposite direction.

My table below gives some perspective on this seesaw of extremes in global risk appetite and how it has affected financial markets …

When risk aversion is king, the dollar wins and practically everything else loses. And conversely when risk appetite improves, that trade reverses.

If the final weeks of 2009 are any indication, it looks like risk will remain central to global markets in 2010 …

For example, risks of a sovereign debt crisis are elevating. So is the risk aversion barometer. As for the risk taking state, it’s been underscored by the prospects of economic recovery.

Now, with the perception that the U.S. recovery is on track, market focus is beginning to shift back to the traditional drivers of capital flow: Interest rate differentials and economic growth differentials.

That’s why we’re seeing the U.S. dollar recover, even while stocks and commodities move higher. A clear decoupling of the correlations we’ve seen to this point that has defined the risk taking component of the risk trade.

Economic Recovery:
Sustainable or Unsustainable?

World economies were sitting on the edge of the cliff and have now stepped back a bit. We’ve seen the positive GDP numbers that have technically ended most recessions. But now the forces pulling and pushing between risk aversion and risk taking are about the sustainability of the recovery.

If the recovery proves sustainable, then the market focus should ultimately transition back toward relative growth and relative interest rate prospects between countries.

But the growth argument has a lot of detractors. There are some very serious problems that remain, and risks that make sustainable growth a low probability.

Here are three key threats that could derail the notion of a return to normalcy, which could swing the international environment squarely back into the risk aversion court. And we know, from the table above, how that impacts currencies and all financial markets.

Threat #1:
Rising Prospects of a Sovereign Debt Crisis

Dubai’s woes could mark the beginning of a sovereign debt crisis.

First it was Dubai that stoked fear in the financial markets over the Thanksgiving Day holiday. Now, Greece has been called on the carpet over concerns that the nation will struggle to meet debt commitments. And Spain, Italy, Ireland and Portugal are all coming under scrutiny for similar reasons.

Debt problems in a global crisis have the ability to be contagious. And that can destroy investor confidence in the capital markets of such countries, and in the global economy. And when confidence wanes, capital flees … a surefire recipe for falling dominoes.

Threat #2:
Asset Bubbles

While ground zero for the credit crisis was the U.S. housing market, new bubbles in real estate are popping up in the areas that were relative outperformers in the downturn (such as China, India and Canada).

When you answer a liquidity crisis with more liquidity, you’re bound to create more bubbles. Central banks and governments have flooded the system with liquidity and money has leaked into assets like commodities, stocks and real estate around the world.

Threat #3:
Protectionism

We’ve already seen evidence of restrictions on global trade and capital flows. Considering protectionism was a key accomplice in fueling the Great Depression, this activity represents a major threat to global economic recovery.

Chinese officials claim that the U.S. duty on Chinese-made tires sends a dangerous protectionist signal.

After the lessons from the Great Depression, the leaders from the top 20 countries of the world vowed to avoid protectionist activity. But actions from the G-20 countries are speaking louder than words. In fact, new trade restrictions have been erected by most of them since the pledge was made.

Perhaps the biggest factor in the protectionism threat is China’s currency policy. Even after recent visits in China by U.S. President Obama and European Central Bank President Jean-Claude Trichet to lobby for a stronger yuan, the Chinese have remained steadfast on keeping their currency weak.

As this issue with China’s currency gains in intensity, expect protectionist acts to rise in retaliation. And expect collateral economic and political damage.

Bottom line: All of these threats point to the rising probability of a “double dip” recession. Another round of recession would send global investors back into their shell and would swing the risk pendulum back toward risk aversion. And based on the table I’ve presented above, we should expect such a scenario to drive the dollar higher and global financial markets lower.

Regards,

Bryan

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amy Carlino, Selene Ceballo, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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