SAFT ON WEALTH-Likelihood and risk are not the same

Wed Jun 25, 2014 3:46pm EDT

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

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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