March 08, 2007

Kamp's Comments - Global Investors Reassess the Risk in "Risky Assets": Economic Activity and Profits Expected to Slow, Not Collapse

by Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF

Over the past three to four years, we have seen global investors' appetite for risky assets soar. Much of that increased risk appetite has been driven by the extraordinary low "risk-free" interest rates that prevailed from 2003 through mid-2005, when yields on three-month Treasury bills hovered close to a meager one percent.

During that period, global investors piled into higher-yielding risky assets in the hope of increasing the returns from their portfolios. As a result, prices on equities and below-investment grade (BIG) bonds rose sharply, setting multi-year records in some parts of the market.

Price increases in the bond market caused yield spreads (the difference in yield between a bond and a U.S. Treasury security of the same maturity) on high-yield and emerging market bonds to hit multi-year lows, reflecting how little investors were demanding as a premium for assuming the increased risk from investing in those riskier bonds.

A similar phenomenon was seen in equities, especially emerging market equities. By early this year, many equity markets around the globe had soared to multi-year highs, in some cases doubling (as in China) or tripling (as in India) in value over the past two years. The combination of robust earnings growth in a rebounding global economy and investors' increased appetite for risk probably explains much of the meteoric rise we saw in those markets.

With those gains, volatility appeared to sink to multi-year lows (as indicated by measures keenly watched by investors, including the prices on equity market option contracts). In short, it seemed that there was only one way for prices on risky assets to behave — to rise to even greater heights.

But good times eventually end, or at least become far less certain. With the Fed starting to raise interest rates in mid-2005 and other central banks following the Fed's lead in late 2005 and early 2006, the seeds were sown for eventual erosion in the quest for yield by global investors.

As central bankers around the globe progressively tightened the monetary screws, two things have happened: 1) global economic activity and corporate profits have started to slow; and 2) the yield premium for holding risky assets (or the yield spread on those assets versus "risk free" assets) increasingly looks less attractive, especially compared to the higher yields that can now be garnered from investing in "risk-free" short-term investments.

In that context, the events of the late February and early March are not all that surprising. Investors are now focused on the realities presently facing us — economies and profits are slowing and, given that, spreads on risky bonds are probably much too low.

The result of all this is that most equity markets around the world have corrected from record, or near-record, highs, and that risky bond spreads have risen from record-lows. In other words, investors have concluded that pricing for risk was too low and that an upward repricing of risk is required.

Hence in the closing days of February and into early March, investors moved away from risky assets and gravitated toward much less risky assets such as Treasury securities.

How long will this increased market volatility last? Only time will tell. However, one should keep in mind that economic activity and profits around the world are only expected to slow, not to collapse. Should those expectations prove wrong — if recession looms or financial markets continue to take a beating — one can be assured that monetary authorities would likely turn quickly to aggressive easing to revive economies and financial markets around the globe.

Leo also is available to comment on economic data. If you wish to speak with him or to be removed from future distributions, please notify Chad Peterson at 1 212 916-4808 / cpeterson@tiaa-cref.org.

Kamp's Comments are prepared by TIAA-CREF Asset Management and represents the views of TIAA-CREF's Investment Strategy and Client Solutions Group. These views may change in response to changing economic and market conditions . Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.

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