Reciprocating Risk...

Interesting article that echoes some of the themes discussed on this blog:

NEW YORK (Dow Jones)--Some money managers are preparing for the next stage of the global financial crisis--a world where the traditional perception of risk has been turned on its head.

Sovereign debt from the industrialized countries, particularly the U.S., the euro zone and Japan, was once perceived as the safest of investments and the benchmark by which to measure all other assets.

But massive debt loads as a result of the global banking crisis eroded sovereign debt creditworthiness, meaning investors have to rethink long-held beliefs and investment strategies. Assets that were once perceived as risky--such as emerging markets or corporate debt--are now viewed as less risky than debt sold by large developed economies such as Spain.

Greece's downgrade by Standard & Poor's into junk territory this week is merely the tipping point in what is likely to be a fundamental adjustment process that will last much longer than most realize.

"You need to think about the unthinkable," such as sovereign default and a world without AAA-rated nations, said Scott Mather, Pimco's head of global portfolio management, overseeing $41 billion in global bonds.

Greece is just the beginning: Portugal, Spain, Italy, the U.K. and even the ultimate safe-haven, the U.S., are being re-evaluated by wary fund managers looking to avoid exposure to assets that could suddenly lose sharply in value because of their government's poor fiscal management.

"We are seeing a broader repricing of G-7 credits versus the rest of the world," said Lena Komileva, economist at Tullett Prebon in London. "The most fundamental transformation in recent developments is to rethink investment grade sovereign credit."

The upshot could be "a huge systemic shock," she said, not unlike the collapse in financial markets after Lehman Brothers was allowed to fail, also due to a mispricing of risk.

For sure, the view that the world of investing has fundamentally changed has yet to be widely shared. Stocks in the U.S. just had their best quarter in decades, high-yield issuance is setting records and premiums on risky assets have tightened to historically low levels. Goldman Sachs, for example, recommends investors cut back on their exposure to risky assets, but remains positive on growth-sensitive assets in the medium term.

But those who expect a drawn-out period of adjustment--which also spells low growth and low inflation--urge investors to consider the impact of sovereign risk for every country across all asset classes. They advise investing in the assets of countries with healthier fiscal accounts, such as Australia, Canada, Germany, Mexico and Brazil, and in companies operating in these nations.

Investors should brace for lower gains than they are used to, and more volatility. They should also avoid switching from pressured bonds into stocks, especially since bonds usually outperform during periods of depressed growth and muted price pressures.

Within the fixed income universe, asset classes are less important than regional vulnerabilities--a trend that Chris Diaz, a global bond portfolio manager at ING Investment Management, expects to gather pace. "You're starting to see this convergence around the world," he said.

His portfolio, once stocked with sovereign debt, is now focused on U.S.6 credit and mortgage-backed bonds, "and other things that would usually be considered riskier than sovereign debt," he said.

The elephant in the room is the U.S.'s own debt burden. The focus of recent fears has been on the euro zone, because of the massive debt held by some of the members--Italy alone has EUR1.7 trillion in debt outstanding--the immediacy of debt payment deadlines and the fact that member countries have no control over the exchange rate.

The dollar, on the other hand, is the world's reserve currency and capital markets are deep and liquid. But the government's debt burden, already massive, will continue to grow as deficits remain high: Barclays Capital forecasts a budget deficit of $1.7 trillion in 2019, with interest payments accounting for nearly a quarter of the budget.

As this week's record debt-raising proved, Treasurys continue to enjoy solid demand as the ultimate safe haven in times of trouble. But the clock is ticking for the U.S. and other heavily indebted developed nations.