ANALYSIS

Real credit the only opportunity in the new regime: Watson Wyatt

Carl HessInvestors must recognise that the economic world has changed and not expect normal asset price reversion in the future, says Carl Hess, Watson Wyatt’s global head of investment consulting.

Hess says investors should pursue “regime-change” thinking rather than hold out for mean-reversion in asset prices, and be prepared for a range of extreme outcomes as the global financial and economic system experiences further debt deleveraging, high volatility and government intervention.

“In this very changed environment, caused by fundamental structural shifts, we believe ‘regime-change’ thinking is more important than ‘mean-reversion’ thinking,” Hess says.

The consultant was expounding on Watson Wyatt’s Global Investment Matters paper for 2009, which presents the case for regime-change thinking and puts physical credit as the exposure of choice for the foreseeable future.

As market participants continue to reduce leverage in order to conserve capital and balance sheets, prices for cash and synthetic exposures have diverged – for example, investment-grade bonds and credit default swaps – making physical exposures in the bond market attractive on a long-term basis, the paper states.

“This premium for liquidity is typically elevated in uncertain times, but is especially high at the moment given global, economy-wide deleveraging dynamics.”

But the market is impaired by structural debt problems, and these will be difficult to fix.

“At the ‘big picture’ level, the cause-effect linkages are complex and it is hard to know which assets will be the main beneficiaries.”

However, the premium for liquidity was high as “market participants are forced to deliver and deal with assets that are difficult to price and difficult to sell”.

While credit risk premia have risen, genuinely long time horizons might be needed to earn decent returns, Watson Wyatt writes.

Building its case for regime-change thinking, the consultancy says that future returns from all asset classes were significantly uncertain because the economy is unlikely to return to its previous state.

“Housing and debt bubbles, banking system crises and excess leverage and balance of payments imbalances typically take considerable time to unwind.”

“These will create significant multi-year headwinds for spending and economic growth.”

Moreover, for investors, the frailty of the financial system, and its knock-on impacts on the real economy, have caused many assets to be faced by structural macro headwinds.

There is also risk of further credit losses, tighter credit conditions and more deleveraging within financial institutions’ balance sheets.

With two US bear market rallies already behind us, volatility will continue to be high due to macroeconomic uncertainty and problems in the financial system.

Asset prices will also be influenced by political intervention.

“The usual rules of capital markets have been suspended, with government intervention and elevated political involvement having a large potential influence on outcomes for different investments, making for unfavourable risk/reward trade-offs.”

In some cases, investment outcomes are reliant on the “timeliness and aggressiveness of the ‘right’ policy responses”.

“Regime change” thinking and understanding on a deterministic basis the impact of extreme outcomes would be a good place to start to determine investment strategy.”