The RBA’s biannual Financial Stability Review (FSR) has become essential reading since the financial crisis, even for stock-pickers.  The central bank has used the October issue as an opportunity to vent about its concerns surrounding investor complacency in global financial markets.  It has cited some of these concerns previously, but the language it is resorting to now suggests that its patience is wearing thin.  Below is the list of key risks that the central bank has identified.

• In the FSR from April 2017, the RBA pointed to the risk of a sharp decline in prices of risky assets associated with a sharp reversal of the ‘search for yield’ trade.   That language has now been more hard edged; low volatility and interest rates are facilitating excessive risk taking via a search for yield, increasing the risk of a ‘disruptive correction.’  In particular, high asset values and low market volatility suggest that investors might be under-estimating downside risks.  Any number of uncertainties – if they were to transpire – could ‘trigger a reappraisal of asset valuations and a spike in volatility.’
• Previously, financial stability risks in China were elevated; debt had grown significantly over the past decade, with strong growth in lending from less regulated and opaque parts of the financial system.  The RBA has now added that these developments have ‘led to ‘considerable credit, liquidity and contagion risks in the Chinese financial system.’  Moreover, the ‘authorities face a challenging transition away from growth strategies associated with rising debt.’
• Previously, conditions in commercial property markets were described as strong in Melbourne and Sydney, and weak in Brisbane and Perth.  Now, the RBA has expressed ‘some concerns about non-residential commercial property markets’, with prices continuing to outstrip in Sydney and activity subdued in some other cities.

One of the key lessons taken by central banks from the financial crisis has been to become more pro-active around managing financial stability and calling out what they see as unsustainably high asset valuations.  In the lean versus clean debate around the delicate task of managing asset price bubbles, the RBA has drawn its line in the sand, preferring to lean against what it considers to be speculative excesses.  For asset allocators and stock pickers, the challenge remains market timing.  It remains to be seen if the RBA’s warnings are as premature as were Alan Greenspan’s concerns about ‘irrational exuberance’, expressed in December 1996.

​Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.

Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.