Return OF Capital vs. Return ON Capital – What’s in Store for 2010?

When Bernanke announced back in 2009 that he saw “green shoots” in the U.S. economy, it was a green light for global investors to start dipping their toes back in the water. Gradually investors started feeling better about the world and as they felt better, they started taking on more risk. It was a shift in focus, away from the mandate of “return OF capital” back toward one of “return ON capital.” So, what’s in store for 2010? Will it be risk-aversion or risk-taking? Words: 794

In further edited excerpts from the original article* Bryan Rich (www.moneyandmarkets.com) goes on to say:

A Recap of the Risk Trade
When risk-aversion is king, the dollar wins and practically everything else loses and, conversely, when risk-appetite improves, that trade reverses. If to date is any indication, it looks like risk will remain central to global markets in 2010 as exemplified by the elevation in the sovereign debt crisis.

Now, with the perception that the U.S. recovery is on track, market focus is beginning to shift back to the traditional drivers of capital flow i.e. interest rate differentials and economic growth differentials. That is why we’ve seen the U.S. dollar recover, even while stocks and commodities move higher.

Economic Recovery: Sustainable or Unsustainable?
World economies were sitting on the edge of the cliff back [in the fall of 2008/winter 2009] and have now stepped back a bit. We’ve seen the positive GDP numbers that have technically ended most recessions but now the forces pulling and pushing between risk-aversion and risk-taking are about the sustainability of the recovery.

If the recovery proves sustainable, then the market focus should ultimately transition back toward relative growth and relative interest rate prospects between countries. The growth argument has a lot of detractors, however. Some very serious problems remain and risks that make sustainable growth a low probability.

3 Key Threats
Here are three key threats that could derail the notion of a return to normalcy and swing the international environment squarely back into the risk-aversion court:

Threat #1: Rising Prospects of a Sovereign Debt Crisis
First it was Dubai that stoked fear in the financial markets. Now, Greece has been called on the carpet over concerns that the nation will struggle to meet debt commitments. In addition, Spain, Italy, Ireland and Portugal are all coming under scrutiny for similar reasons.

Debt problems in a global crisis have the ability to be contagious and that can destroy investor confidence in the capital markets of such countries, and in the global economy. When confidence wanes, capital flees … a surefire recipe for falling dominoes.

Threat #2: Asset Bubbles
While ground zero for the credit crisis was the U.S. housing market, new bubbles in real estate are popping up in the areas that were relative outperformers in the downturn (such as China, India and Canada).

When you answer a liquidity crisis with more liquidity, you’re bound to create more bubbles. Central banks and governments have flooded the system with liquidity and money has leaked into assets like commodities, stocks and real estate around the world.

Threat #3: Protectionism
We’ve already seen evidence of restrictions on global trade and capital flows. Considering protectionism was a key accomplice in fueling the Great Depression, this activity represents a major threat to global economic recovery.

After the lessons from the Great Depression, the leaders from the top 20 countries of the world vowed to avoid protectionist activity but actions from the G-20 countries are speaking louder than words. In fact, new trade restrictions have been erected by most of them since the pledge was made. For example, Chinese officials claim that the U.S. duty on Chinese-made tires sends a dangerous protectionist signal.

Perhaps the biggest factor in the protectionism threat is China’s currency policy with the Chinese remaining steadfast on keeping their currency weak. As this issue with China’s currency gains in intensity, expect protectionist acts to rise in retaliation and expect collateral economic and political damage.

Conclusion
All of these threats point to the rising probability of a “double dip” recession and another round of recession that would send global investors back into their shell.

This would swing the risk pendulum back toward risk-aversion and such a scenario would drive the dollar higher and global financial markets lower.

*http://www.moneyandmarkets.com/risk-aversion-vs-risk-taking-whats-in-store-for-2010-6-37069 (Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil.)

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