Likelihood and risk are not the same

June 25, 2014

June 25 (Reuters) – The GDP release is a salient reminder
that right now, the big risk for most investors is that the
consensus is too complacent.

How else to interpret a world in which U.S. growth falls at
an unexpectedly steep 2.9 percent annual clip in the first
quarter and yet stocks rally?

One easy conclusion is that everyone is leaning more or less
the same way, making the risk, if not likelihood, of an upset
all the greater. Low-probability events can have outsized
impacts.

That fall in GDP, the sharpest in five years, was driven by
a decline in inventory buildup and health care spending, but
cemented by weakness virtually across the board. Final sales, a
measure which excludes inventories, actually fell by 1.3
percent.

Now, the narrative which argues that the first quarter was
just a weather-induced blip in a slow recovery has merit, and is
more likely than not.

Data has improved considerably since the weather improved,
with four straight months of 200,000 or more jobs created,
strong consumer confidence and much better sales of big-ticket
items.

That, in combination with a faith that the Fed will keep
liquidity ample, has encouraged investors to bid the benchmark
S&P 500 stock index to a healthy 6.5 percent gain so far
this year. The attitude, best described as ‘things are OK, just,
and the Fed has our back,’ has also driven strong flows of funds
into riskier areas of the debt market, allowing weaker borrowers
to secure better terms with fewer protections for lenders.

The market in short is complacent, with a good bit of
cynicism. And unlike 2000 or 2007 when greed fueled the party,
this time a lack of volatility has acted as an anesthetic.

Even so, there are weaknesses in the way in which investors
are putting their faith in the recovery into practice.

First, from a risk management perspective the consensus is
so strong, even despite some very troubling data points, that it
virtually invites an over-reaction should data begin to weaken
and the recovery thesis look less strong.

Consider the recently released Bank of America/Merrill Lynch
survey of global fund managers for June. Investors have been
overweight global equities, the broadest classification, since
very early 2013, an historically long period. Even more
strikingly, nearly nine in 10 fund managers think 10-year U.S.
government note yields will end the year over 2.50
percent, representing an incredibly strong consensus that we are
now at the bottom for yields. Everyone is leaning the same way.

BEING RIGHT VS MANAGING RISK

All investors face a tension between what they want, which
is to be proven right by events, and what they so often really
ought to do, which is manage risk.

While I understand and almost agree with the
bumble-along-and-trust-in-the-Fed thesis, I think it fails on
the risk management front. Very few called the first-quarter
growth figures correctly, which argues that we could easily be
collectively wrong again.

That brings us back, again, to the Fed, which many investors
seem to regard as a kind of FDIC of risk investing, insuring
them against the possibility of unsatisfactory gains.

What, exactly, will the Fed do should the data weaken? There
is nowhere to go with rates themselves, other than jawbone about
more delays to rises. QE could be re-upped, but given that the
Fed would be doing so after it more or less already failed, that
may not inspire confidence.

Second, if you look a bit more closely at the data and the
economy there seems little room for improvement in the second
half, much less the kind that is needed.

While job creation has been pretty good, wage growth, which
is the real foundation of better final sales, has not.

That leaves the economy depending in the second half on more
corporate investment. Fixed investment in the first quarter fell
at a 1.8 percent rate, with investment in equipment falling at a
2.8 percent rate.

In the absence of some strong pick-up in demand from abroad,
it is really hard to see businesses suddenly getting aggressive
about investment unless consumers have more money to throw
around. And with wage growth largely stagnant, even after all
these months of falling unemployment and decent job creation,
that is not likely.

That leaves most of us effectively betting that an economy
which is only going to grow 2 percent or so a year will somehow
be able to continue to create strongly growing corporate profits
and 10 percent equity returns.

The faith in the Fed, that it would keep conditions easy
until the economy grows well on its own, is founded on the idea
that at some point that growth would actually happen.

The longer we go without that happening, the higher the
chances are that at some point that faith falters.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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