Mr Goodwin – also known by his pseudonym “Mr Risk” – points out that the Federal Reserve’s policy of Quantitative Easing (QE) has created difficulties in pricing assets in the capital markets.
“When you are in a quantitative easing regime you are almost divorcing economics from financial markets because you have this central bank’s backstop of liquidity,” Mr Goodwin stated.
The financial analyst points out this has “absolutely crushed volatility” and “compresses risks premiums”, causing many investors to be pushed into riskier, high yielding assets.
“QE really supports a misallocation of capital into assets that are the prime beneficiaries of QE, which means fixed income securities, high yield emerging market bonds,” he said.
Many commentators would agree that the Fed has caused a drive into riskier assets. However, Mr Goodwin – who is known for his contrarian views – says there is potential for this to cause systemic problems.
“The other thing about high yield is to think what sorts of risks are associated with high yield that could lead to contagion across the broader financial system,” he asks.
The former Lehman Brothers strategist believes there are potential dangers in the “equity demand” characteristics of the capital markets, particularly amongst high yield mutual funds and high yield exchange traded funds (ETFs), as investors can pull their money out of these funds, forcing asset managers to sell in an illiquid market.
“[The] fact that this equity demand characteristic is very similar to what we saw in the last financial crisis, when we have the debt demand link, the link between money markets and subprime, that is potentially a very worrying thing,” Mr Goodwin said.
“If the credit quality of high yield dissipates, you could actually see the same debt demand link cause a broader contagion of the financial system.”
