Risk Appetite Weighed by Forecasts for Recession, Looming Financial Risks

• Risk Appetite Weighed by Forecasts for Recession, Looming Financial Risks
• Financial Leaders Defer the Government’s Withdrawal From the Market at G8 Meeting
• US Banks Suffer Downgrades, European Officials Refuse Stress Test

The market finally saw its steady rise in optimism knocked off track this past week. After such a heady buildup in sentiment, it took the collective influence of dreary growth projections, growing financial troubles and the G8’s refusal to cater to investors’ sentiment-fueled rally to win a temporary break in risk appetite. However, the general bias has not changed. Risk appetite retains the positive bias that has encouraged speculative funds back into the market for nearly four months now. The current period of indecision instead offers an opportunity for fundamentals to truly catch up to price action. Looking across the more popular measures of risk appetite, we have seen the Dow Jones Industrial Average drop below the floor of the 8,600-8,850 range that had equities sidetracked for nearly two weeks. More attuned to the growth forecasts derived from positive sentiment, commodities put in for their biggest correction since late April. Even the more sensitive credit market gauges deteriorated despite the government’s steadfast liquidity and guarantees. Credit default swap premiums have risen more than 17 percent in the past week. How has this shift in attitude presented itself in currencies? The Carry Trade Index has violated its stable rising trend and marked a double top with the peak set at the beginning of this month. With risk reversals and yield forecasts turning lower, the scales of risk and reward seem to be once again shifting.

While they have taken a back seat to sentiment in the past few months, fundamentals have always been there for market participants scrutiny. And, a critical look at the growth forecasts and burgeoning financial troubles at eye level certainly do not support a rabid redistribution of capital into risk assets. This past week, the headline event was the two day G8 summit in Lecce, Italy. Rhetoric from the Finance Ministers was generally mixed; but the official statement maintained a cautious tone. Growth was deemed the top priority; and considerations for the government’s exit strategy was deferred to a later date. Record budget deficits no doubt present a significant long-term problem for individual economies; but they also support an economic recovery in the near-term. This is an important point considering the IMF forecasts the global economy to see its first contraction (1.3 percent) since the Great Depression and there are numerous financial concerns that could quickly escalate into crises. An ongoing risk to the world’s financial markets is the health of US banks. Just this past week, Standard & Poor’s downgraded 22 American banks – seven of which were TARP recipients. And, despite the lingering risks with liquidity and future earnings, nine of the 19 banks that were put through the stress test paid back a total of $68 billion of their government loans. The trouble isn’t isolated to the US though. European officials refuse to perform a stress test on their own banks even though the ECB has forecasted another $283 billion writedowns this year (the IMF projects $904 billion).

Written by John Kicklighter, Currency Strategist
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