As the year ends, many analysts try to identify the “black swan” event of 2016 in order to warn people about it and allow them to prepare for it.
But I think what we should be cautious about is the “butterfly effect” in the market.
The subprime mortgage crisis in the United States triggered the financial meltdown of 2008. The root cause was credit risk.
In previous years, the global economy and the valuation of different asset classes were under an environment of high liquidity and super low interest rates.
Money can solve problems, but its value depends on the users’ confidence in it.
Currently, the cost of capital for many companies is at its cheapest level. Although the Federal Reserve has started raising interest rates, the central banks of Europe, Japan, the United Kingdom and China are maintaining a loose monetary policy.
However, the impact of quantitative easing methods is no longer as strong as it was. Every extra supply of dollar may only bring a stimulus effect of ten cents.
Before the Fed raised interest rates, the hedge fund Third Avenue, which focuses on junk bonds, suspended the redemption of its funds on Dec. 10 because it has lost 27 percent of the carrying value since the beginning of the year.
Its assets under management decreased to less than US$800 million from US$3 billion. Another hedge fund, Stone Lion Capital, also suspended redemption.
This means that although there’s ample liquidity in the market, some things won’t ever happen.
The logic is simple. If a company carries a borrowing cost of 10 percent, 20 percent or even higher, from what kind of business can it gain a profit margin higher than the capital cost?
The chances of finding one are rare.
The major economies reported slow GDP growth this year, with the US growing by less than 3 percent, Japan and Europe by 1 percent or lower, and China slowing to 6.5 percent.
The other side of high yield is high risk.
If the economy is sluggish, no matter how low the interest rate is, there will always be credit risks.
How large will such a butterfly effect be? Investors should be extra careful in 2016.
This article appeared in the Hong Kong Economic Journal on Dec. 31.
Translation by Myssie You
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