Risk Adjusted

Financial markets have had the wind at their backs for the last few years. Historically low interest rates, the economic rise of China, India, Russia and Brazil, and consistently strong corporate earnings made for heady increases in stock and commodities markets around the world. This has created the illusion that just about any bet — even the risky ones such as sugar futures and Indian pharmaceutical companies — was bound to pay off handsomely.

Since May, that optimism has been challenged. Today asset prices are being weighed down by two powerful forces: monetary policy and geopolitical angst. This spells "risk reduction" for most investors — a far cry from the "risk-hungry" investment strategies that have worked so well over the past several years.

Why the sudden concern about risk? One factor is that central banks are finally coming to their senses. After more than five years of ultra-loose monetary policy, the world's major monetary authorities are all on the tightening side of the policy equation for the first time since the early 1990s. As a result, interest rates are going up, setting the stage for slower expansion of the money supply. This is occurring for two reasons. First, central banks are now satisfied that deflation has been avoided — an especially big deal for the Bank of Japan, which just abandoned nearly six years of zero interest rates. Second, authorities are concerned about the risks of incipient inflation. So-called core inflation gauges have accelerated in a climate of sharply rising energy prices. Determined to avoid the mistakes of the 1970s, central banks have been quick to tighten in response.

This changes the rules of engagement for investors, who are now being denied access to the cheap funds they were putting to work chasing higher-yielding investments in emerging markets or subprime corporate debt. Indeed, stocks and bonds in emerging markets, which soared when money was plentiful, now stand to lose the most — and not just because global liquidity is returning to normal. There is also a chance that a likely slowdown in U.S. consumer demand would crimp the economies of export-led developing countries. China and Mexico would be especially vulnerable, as would the rest of an increasingly China-centric Asian supply chain. Nor has the developing world become more self-sufficient. While pan-Asian trade has increased significantly since the late 1990s, much of the trade is driven by demand for commodities and components to feed China's factories — which in turn rely heavily upon the U.S. as the consumer of last resort.

Heightened geopolitical tensions could compound the risks in the markets. The rapidly escalating conflict in the Middle East, along with the North Korean missile crisis and another terrorist attack in India, has already led to a ratcheting up of oil prices. Higher oil prices, bad for businesses everywhere, may be particularly damaging right now. That's because they place another burden — more expensive gasoline and utility charges — on U.S. consumers, who are short of savings and unable to sustain their spending by borrowing against their homes in a weakening housing market. This spells trouble for a global economy still overly dependent on the U.S. consumer.

That's not to say the world lacks resilience against geopolitical shocks. Morgan Stanley estimates global gdp will grow 4.7% this year. That's 40% faster than the 3.4% average gains in the pre-oil-shock years of 1979 and 1990. Strong growth provides an important cushion to ward off unexpected blows. At the same time, the so-called stewards of globalization — namely, the G-7, the imf and the world's major central banks — are now focused on implementing policies that would temper worrisome global imbalances.

But we can no longer count on an abundance of cheap money sloshing around the world to act as a bulwark against calamity and push asset prices higher. Financial market conditions today are more treacherous, margins for error are smaller, and even if there is a miraculous resolution of current geopolitical tensions any sigh of relief by investors is likely to be fleeting. The days of making easy money on risky assets are behind us.