GLOBAL markets are on a journey into the unknown, with asset prices increasingly determined by a handful of politicians and technocrats without the bedrock once provided by risk-free sovereign debt. UBS head of global sovereign research Michael Dow said that the explosion in public debt, and the frantic efforts by politicians and policymakers to deal with the consequences, had produced an environment where "policy risk" now determined asset prices. "The actions of the Federal Reserve, the European Central Bank or the President of the US with congress on fiscal stimulus are now more important for valuations than assessing cashflows and discounting them back," Mr Dow said. "Instead of stocks and bonds being determined by the market, there is a total of about 12 to 15 people making the decisions that affect asset prices." The inevitable result, he said, was a heightened degree of risk associated with investment, because fundamentals were no longer as important. Mr Dow, who is visiting UBS clients in Australia, had a background in credit before taking up what was a new position at the investment bank. His main thesis in examining the global debt crisis is that markets have lost the guidance once provided by the perceived risk-free rate on short-term sovereign debt. Not only did this up-end asset pricing models, but it also undermined the credibility of the banking system, he said. With previously stable bond yields showing unprecedented volatility, banks had lost an investment safe haven to offset the risk of lending. "That means credit contraction, and deleveraging of the banking system is the result," Mr Dow said. The crumbling of the risk-free rate had been compounded by the loss of any historical perspective, he said. Yields on 10-year Netherlands bonds were at a 500-year low. Similar US securities were in a 220-year trough, and multi-century lows were also being recorded in Britain and Japan. Policy rates in Britain had not seen their current levels in 317 years, or 100 years for those in the US. Intervention by policymakers had also reached an all-time high, with central bank balance sheets reaching 20 per cent-plus of GDP in the US, more than 30 per cent in Japan, and somewhere in between for the Bank of England and the European Central Bank. Mr Dow said it all led to him being more uncertain about the investment horizon, adding that the world "had to do something to make us feel better". Asked what that might be, he jokingly pointed to the 16th floor window, saying: "Unfortunately it's locked." On Australia, though, there was greater cause for optimism, despite the desperate political lunge for a surplus when debt levels in this country are very low compared with crisis-hit European nations and the US. "From a pure credit perspective, Australia dominates other developed markets in large part because of its fiscal freedom -- the degree of freedom to engage in fiscal stimulus here is substantially greater than any other place because of where your debt dynamics began," Mr Dow said. "It's a very positive story from a credit perspective." For the rest of the developed world, or at least most of it, the imperative was to deleverage so that stability -- and the risk-free rate -- could be restored. There were three different ways to go about it. First, the debt could be serviced and the principal repaid through growth. Second, the debt could be eroded away -- in proportional terms -- through inflation. Mr Dow said this solution appeared to be on offer, with repeated exercises around the world in quantitative easing, which amounted to printing money. The third option, which was the worst outcome for bondholders, was default. By far the most effective way to deleverage was through growth. "If you think the predominant pathway will be debt service and growth, you should invest in riskier assets like equities and high-yield bonds," Mr Dow said. "If you think it's inflation, you should consider infrastructure, real estate and commodities, but if you think it's default, then cash is the only safe place to be . . . Move to a cave by a pond of fresh water with wild game nearby."

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