Understanding the financial cycle - Look for where risks will materialize

The researchers at the Bank of International Settlements (BIS) have spent a lot of time developing the concept of the domestic and global financial cycle. This work has advanced our understanding of capital flows around the world.(See, for example, "Global and domestic financial cycles: variations on a theme", "A tale of two financial cycles: domestic and global", "How important is the Global Financial Cycle? Evidence from capital flows") 

I want to focus on what is a key concept of this work, the idea that risk across the financial cycle is not high or low but is rising and then materializing. The materializing of risk leads to changes in behavior which will cause the turning points in the financial cycle. While this distinction may be viewed as subtle, it is critical for investors who want to be prepared for swings in the financial cycle.

Whether a domestic or global financial cycle, changes in the financial environment are manifested through the flow of capital to risk-taking ventures. Excessive capital flows can occur when there is greater credit availability for risk taking above what is necessary to support economic growth. Credit allows for higher leverage and generates increases in collateral prices as asset valuations increase. Risks will build given the availability of cheap money, higher leverage, and increased valuations. 

Investors need to focus attention on those places where risks will materialize. This is not a function of looking at macro variables but studying specific markets which will be affected by capital flows and overvaluations. Macro risks are the summation of increases in the risks of individual market sectors. Investors who want to make money need to analyze the micro flows and how they will be affected if there is a macro catalyst. This could be at the country level, a domestic financial cycle, or at the global level, when capital is cheap across all countries.

The amplitude of the financial cycles has gotten higher because the Fed and other central banks have fueled credit expansions. When risks have materialized, which would have created market retrenchment and risk avoidance, central banks have furthered the credit expansion to stop the adjustment process. Macro-prudential and regulatory policies have been used as an offset to plug leverage problems while maintaining credit expansion. The post GFC period saw an increase in banking regulation to cut leverage excesses only to now have them appear in other market sectors, CLOs, cov-lite lending, and other forms of shadow banking. Cheap credit from the Fed fueled the global financial cycle and the great EM leverage increase. 

Volatility has fallen, yet this is not a measure for an investor's focus. Eyes should be on the risk builds and where they will materialize. Investor focus has to be on the largest beneficiaries of the great post GFC credit expansion and look how an adjustment will play-out given the current round of central bank stimulus.