Credit contraction pain poses high risk

Susan Gosling

The behaviour of both investors and policymakers will determine how painful the financial markets’ adjustment will be to a necessary period of credit contraction, according to Susan Gosling, capital markets research, MLC Investment Management.

She said “dramatic credit expansion must inevitably be followed by a credit contraction”, adding that “it is very difficult to see that this will not mean slower economic growth or recession and lower returns from equity markets”.

It is not also possible at this point to determine how far markets are through the adjustment process, she said.

“Our assessment is that although the investment environment includes clear long-term structural positives, it also remains one of relatively high potential risk.

“There is obvious risk — though by no means certainty — of an escalation in the crisis, but we do not believe that there can be certainty as to whether a full scale selling panic will eventually occur.”

Attempts by policymakers to boost growth in the US through fiscal and monetary policy may backfire by increasing rather than eliminating the underlying excesses, she said.

While markets may have applauded the dramatic 75bp cut in interest rates by the US Federal Reserve in January, she said, “Over-accommodation by the Fed is at the heart of our current problems”.

“Over-willingness to bailout takers of inappropriate risk encourages them to take more risk, and the moral hazard it creates is extremely dangerous and can seriously undermine economic stability.”

A major impediment to effective risk management is investors’ focus on past returns, she said, forcing investment managers to limit the extent to which they stray from peer funds.

“In doing so, investors are effectively defining the range of asset allocations that are acceptable, which seriously limits the ability of managers to focus on absolute return objectives.”