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The world is well aware that Europe’s sovereign debt crisis could lead to contagion within the economic region, and around the world. But changes in sovereign debt markets also pose a risk to pretty much every other asset class, according to Pimco’s Scott Mather.From Pimco’s Scott Mather:
To start with, I suggest putting aside any typical cyclical model that may have been useful in the past. Over the secular horizon, say the next three to five years, we argue that market behaviour may be vastly different than what models would predict. One reason: sovereign debt, which is at the core of our global financial system, is undergoing a seismic shift. We expect that over the next several years, one way or another, this core will degrade in creditworthiness. So investors have to wonder, what does it mean when the core weakens?
Investors may find it more difficult than they expect to avoid sovereign debt risk. Media reports seem to suggest the sovereign debt problem is concentrated in peripheral Europe and if that can be addressed then the problem is solved. In reality, peripheral Europe is distracting people from problems in the much larger developed world. And, I argue, one cannot escape sovereign debt issues simply by moving into other asset classes, because equities, real estate and all other investments will be affected if sovereign debt of a nation deteriorates.
Thus, policy decisions over public deficits could be paramount to investors, as well as central bank moves to buy or sell government debt or direct interest rates.
This is true for a lot of reasons. One interesting one is that, when calculating the value of an asset using a discounted cash flow model, sovereign debt (often U.S. treasuries) act as the risk free asset. Thus, changes in the value of sovereign debt brought on by a sovereign debt crisis could impact the valuation of all assets, including equities and real estate.
In a more obvious way, investors concerned about rising bond yields, or default, are likely to move into less risky assets, like cash. If inflation is rising simultaneously, this may not be the case. But all and all, volatile sovereign debt markets do damage to the way investments are value, even in the most basic formulas.
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