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The Governor of the Reserve Bank, Glenn Stevens, is not into market timing.

This might seem at odds with his role as the country's most influential banker that requires decisions based on forecasts of future economic activity.

But if you look at his speech this week at a financial markets conference in Sydney which gives a great context for the international financial market turmoil of the past six to eight months you also get a sense of why precise timing of market moves is such a difficult thing to pull off.

First the good news. Despite the impact of the US sub-prime collapse on the financial services sector the Australian system has stood up well and while there are clear signs of pockets of stress across companies and households there is no evidence that a sub-prime type collapse is lurking beneath the Australian banking system landscape.

Stevens traces the genesis of the recent market turmoil to back to the 1990s - in part he argues that the Asian crisis of the late 1990s and the determination to avoid a repeat of it was a factor, along with the sudden rise in Chinese incomes.

Stevens says that that combined with an unusually stable period on the macroeconomic front which resulted in a "great moderation" in volatility that saw default rates on corporate debt, even sub-investment grade, fall to unusually low levels during the past decade all helped fuel the situation.

"In my mind there is little doubt that this lowered perceptions of risk �" Stevens says.  "In this environment, the search for yield continued. This saw end investors consciously begin to accept more risk in order to find the returns they were seeking."

Stevens says this provided the backdrop for the development of new financial instruments. "The innovative financial community obliged and provided ever more sophisticated ways of achieving the returns desired by investors. The innate complexity and, in some cases, opacity of these instruments made their properties hard to assess. With this reduced transparency, it was easy for investors to underestimate the risks that they were taking on," Stevens says.

Regulators, central bankers and private bankers were not blind to this, according to Stevens, and "eventually something was going to occur that would trigger a reappraisal of risk".

He says any number of events from credit rating downgrades on some major US companies' debt, a default on foreign debt by Argentina, the large rise in the oil price or the tightening of US monetary policy in 2006 could have triggered the reappraisal of risk but barely dented financial sentiment until the full scale of the sub-prime mess became clear.

So if you accept Stevens' argument then a group of some of the world's top central and private bankers knew the situation could not be sustained - they just didn't know when the credit merry go round would end or what the eventual trigger might be.
And it is the sentiment swings that are clearly the hardest to try and time decisions around.

Our Reserve Bank Governor now sees the pendulum having swung dramatically the other way. While he is not downplaying the challenges that still lay ahead and says that financial institutions and investors have continued to be wary of what credit losses may yet be unearthed.

Despite that "it appears that some very high-quality assets are valued at prices that embody extremely pessimistic assumptions about returns".

"Real savings are still flowing into pension funds, insurance companies and other institutional investment vehicles. This is genuine capital, seeking a productive use. But these investors appear to be taking a more cautious approach to risk, given the short-term uncertainty over asset valuations.

"At some point investors who are currently on the side-lines will need to summon enough confidence to take up the opportunities for profitable exposure to risk."
He does outline what he believes investors will need before we can call an end to this saga. Investors will need a reasonable level of confidence that the bulk of the losses have been disclosed and risks to asset growth from the slowdown in major countries are manageable and within normal parameters.

Bottom line is that Glenn Stevens believes this credit crisis and economic cycle will pass - it's just the timing he is unsure of.


By Robin Bowerman
Smart Investing
28th March 2008
Principal & Head of Retail, Vanguard Investments Australia