Sheep in Wolves’ Clothing – Capital Market Risks

With extensive official largesse and stirrings of recovery in global economies, capital market risk emanates from “sheep in wolves’ clothing” behavior. Wolves tend to be opportunistic. Sheep gain passive comfort in groups. By our measures, risk premiums have dropped dramatically in junk bond rate spreads and in equities including long term dividend discount rate based as well as earnings based spreads. Risk premiums appear stirring only now in sovereign debt. We believe the primary purpose of portfolio management at large (for individuals, corporations, or government sponsored entities) is to preserve value of holdings and enhance it over time. Portfolio risk now arises from restructurings not allowed to proceed as thoroughly as occurred in Asia (ex-Japan) in post 1997/8 or as occurred in information technology in post 1999/2000. Prior sovereign finance restructuring has extended from allowing inflationary cut the value of indebtedness, to extensive expenditure reductions and most often to tax increases. Unlike Asia at the end of 20th century, the first such restructuring of 2010 amidst political appeal and threats in the Grecian formula of refinance has concerning similarities to innumerable Argentine tangos in finance.

Despite such refinancing, for central banks to avoid becoming sheep in wolves’ clothing, it behooves measured upswing now from policies of extended ease, not a sudden one fell swoop. Similar to Asia a decade ago, risk reduction now also needs governments being frank. Elsewhere for corporate risk reduction, the focus needed is on balance sheet structure and transparency — not just the revenue focus evident ahead of the latest quarter results. In particular, the most urgent frankness needed is from financial institutions much like the challenge assumed in the information technology industry starting a decade ago.

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