A series of storm fronts in the global economy and in geopolitics appears headed for a major confluence, posing serious risks to the households and firms sailing aboard the metaphorical Andrea Gail.
For much of the second quarter, global investors were rebalancing portfolios to reflect higher risk-aversion in the face of increased uncertainty. The New Economy hangover has left many investors overexposed to U.S. assets. In a risk-averse world, money moves to relatively risk-free or, more aptly, less risky assets.
On the Domestic Front
From a total portfolio perspective, being overweight U.S. assets is a riskier allocation. Throw in uncertainty over the U.S. economic outlook, a declining dollar, depressed stock prices in the wake of corporate accounting scandals and weak earnings and political risks (terrorism), and investors need fewer U.S. investments and more non-U.S. investments.
However, the U.S. climate is well known, and so far the domestic storm hasn't been strong enough to upend U.S. consumption. But other fronts are building and could merge to swamp U.S. consumption and asset prices generally, such as corporate debt, the dollar and perhaps even real estate.
A corollary to the fallacy that the New Economy ended large business cycle swings is that old notions of debt loads and equity valuations went out the window as revenue and income had no limit. Companies are facing the consequences of that bravado, although households seem to be immune as long as unemployment doesn't surge.
Pressure is mounting on corporations to service debt that paid for the mergers and acquisitions of the past decade. Investment-grade paper is harder to find, and spreads with U.S. Treasuries are widening. Banks face their own lending pressures.
Amid weak investment banking revenue and the insolvency of firms such as
, incentives are in place for pulling in credit lines. Keep in mind that foreign investors, like domestic investors, were eager buyers of U.S. corporate debt in the last five years.
To date, foreign investors have mainly been sellers of U.S. stocks, but corporate debt seems a logical next step. Moreover, when corporate credit quality deteriorates, banks tighten lending standards -- another vicious cycle in the making unless growth and profits rebound.
Storms are brewing overseas as well, and they will surely elevate risk-aversion among global investors and potentially pressure U.S. assets if, on balance, investors are still overweight U.S. assets.
Turkey looks sickest at the moment. Complicating its politics is the poor health of the 77-year-old prime minister. Keep in mind, too, that Turkey is the recipient of a very large IMF program and has recently bumped up against the Fund over reform. And one cannot overestimate the importance Turkey plays in U.S. and NATO policy in the Middle East. With the Bush administration seeking to build support for the forced removal of Saddam Hussein, a stable and supportive Turkey is a necessary condition.
Then there's Brazil, which seemed on course to avoid any significant contagion from the Argentina default and devaluation. Arguably, Argentina was not a factor in elevating stress on Brazil financial markets in recent months, and politics was the driver. The leftist candidate, Lula da Silva, is well in front in the presidential opinion polls ahead of the early October election. While he has toned down his anti-IMF rhetoric, he is still a major risk to foreign lenders hinting at the possibility of debt renegotiations.
Brazil also increasingly has its back against a wall when it comes to servicing its debt burden and rolling over maturing paper. With more than $215 billion in total debt, a high percentage of it dollar-based, a significant existing IMF program and a myriad of debt maturities this year ($18 billion in July alone), Brazil needs access to foreign savings, and this is becoming more and more difficult.
Banks will not be as willing to let Brazil default as they may have been with Argentina. Indeed, some banks can ill afford another major haircut. And Brazil's financial markets offer little in the way of hedging risk. But as with the Turkey fallout, risk-averse trading dictates that investors lighten up on U.S. assets even before the October election.
While Mexico seems particularly insulated from contagion emanating out of Brazil and the U.S., it suffers from overexposure as well. Investors and financial institutions have plowed into Mexico in recent years, and there is surely risk that some of this will be reversed if risk-aversion becomes more pervasive in global capital markets.
And it's worth mentioning geopolitical risks in the Middle East associated with U.S. efforts to remove Saddam Hussein from power and the ongoing Israeli-Palestinian conflict. These issues have the potential to send oil prices higher and U.S. asset prices lower. And uncertainty will feed the risk-aversion trades.
In addition, premature tightening of monetary policy in Europe could add to concerns about a delayed global recovery. European Central Bank President Wim Duisenberg may have recently lit the fuse for a rate hike with his rhetoric.
Am I predicting a perfect storm for global financial markets and further sharp declines in the dollar and U.S. asset prices? No. But this outcome may be more and more of a statistically significant risk -- one that investors and G7 should consider.
David Gilmore is an economist and partner of Essex, Conn.-based Foreign Exchange Analytics, a currency markets advisory service for institutional investors. Neither the author nor Foreign Exchange Analytics trades in the currency markets. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to