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Risk-appetite grows as markets rally

By Neville Bennett

Friday 6th June 2003

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June has been born in optimism. The mood is contagious. Almost every market is rallying, despite weak fundamentals. This wide and complex phenomenon can be seen as an enhanced appetite for risk.

The Bank of international Settlements also stressed a flood of funds into high-yielding debt. It notes that investors "appear to be willing to take on more credit risk in their search for higher returns." This is obvious in the near suicidal purchase of emerging market debt, especially that of Turkey and Brazil that offer dazzling returns. Net borrowing by developing countries jumped by 52% to $US13.2 billion in the last quarter.

A similar feature appears in corporate paper. Some economists dignify the trend with expectations of higher growth. A realist would say that the response is primarily linked to a quest for higher returns, and damn the risk.

New Zealand investors' enthusiasm for fixed interest has driven yields downward in the past few months. Government bonds now yield 4.86- 5.36%; local authority bonds yield 5.12-5.33%. There are about 17 corporate bonds on issue, with yields ranging from 9.0% to 5.80%. It is extraordinary that business paper ranks so closely to government paper, even though all of the corporates have a credit rating of at least A-. There seems a small premium for risk.

Even more extraordinary is the enthusiasm for capital notes. They are not credit rated. The yields do have a wider spread (from 5.97% to 9%) but the risks with this class of debt do not seem to be perceived.

Moreover, the business sections of newspapers carry a mass of advertising for debentures, secured deposits, etc, which offer 8% for the medium term. Many of these emanate from second-tier finance companies, often involved in short-term finance or hire purchase. Although most have a good track record, the fact remains that a downturn is coming and there will be more bad debts. The advertisers could conceivably default.

Why do ordinary investors never learn that the higher the yield the greater the risk? Fixed interest should be a secure investment. Most secured deposits or debentures do not have a scrap of collateral and their claims rank at the bottom of the queue of creditors.

Note issues also have no real protection but at least they have liquidity (you can sell them on the market) but the other paper locks investors up for two years. Note issuers are also required to provide investors with information, but other issues can say nothing until they fail to return the money. Meanwhile, they can conceal their difficulties by borrowing money to pay the interest on the initial deposits. It is not sensible to risk core capital on second-tier financial institutions in order to get a few dollars more in income.

Euphoria has revived in equity markets. New Zealand has made modest gains but there are still 30+ shares that offer gross yields more than 7%. Tower and Tranz Rail have demonstrated that equity markets are fraught with risk but a holding of value shares is still a valuable part of the average portfolio.

Wall Street is leading the equity charge. It reached its highest point of the year this week. Its up tone has stimulated other markets too.

The most encouraging feature of the Street's rally is its breadth: the number of stocks advancing versus those declining. Days when decliners rule supreme are scarce. This implies new money entering the market, especially as 74% of stocks have been trading over their 200-day moving average. Around 250-400 stocks make new highs for the year each day.

Why is there a rally? Positives include an end to the war, some progress in Palestine and the lowest interest rates for 45 years. A falling dollar is also rated a positive signal.

The economy is harder to decipher. The number of jobless has jumped to 6% or 8.8 million workers. The share market shrugged off this news, although many observers regard the loss of 95,000 jobs in manufacturing as significant.

Wholesale prices have fallen at their steepest rate since records began in 1947. Industrial production fell 0.5% in a month.

The Federal Reserve said that downward pressure on prices is a greater threat than inflation. Deflation may cause more damage if consumers delay purchases in the hope that goods will eventually be cheaper.

Wholesale and retail prices are retreating and pricing power is worryingly weak.

So are not shares in the grip of another bout of "irrational exuberance?" Perhaps not. Equities discount the present and look ahead to the future. If earnings grow, exuberance is not entirely misplaced.

But, there are few signs of increased earnings or greater capital investment.

Why is there a rally? Positives include an end to the war, progress in Palestine and the lowest interest rates for 45 years

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