Markets tend to move like a pendulum from risktaking to risk aversion and back. If 2009 was about taking risk, this year so far has been about shedding it. No one said 2010 was going to be easy. Leading stock indices have fallen 8-9% from their peak as investors zeroed in on threats from fiscal, regulatory and monetary tightening. The threats are real; the risk is that they will be mishandled . But the market, I believe, may regain its poise soon. The current rally, which started last March, remains intact although recent worries have slowed its momentum.
In a historical context, this is encouraging. Strong rebounds are to be expected after great sell-offs, but a few months ago this recovery was outpacing all previous relief rallies. Now, the gains on the S&P 500 since the March low are in line with the gains at the same point in the rally following the great bear market low of 1982. In the long term, 1982 was the start of an 18-year bull market?although that rally fizzled at this point, and stocks moved sideways for months before heading up again (see chart 1).
Investors have, of late, bought protection against the risk of default by a range of governments and companies. Worldwide, they worked through the potential implications of eurozone struggles for their own markets.
Contagion thinking has been behind the recent sell-off across Asia. This transmission mechanism is what investors are beginning to fear. Asia continues to be so dependent on exports to the developed world that if those developed market governments cannot fund their stimulus spending, then they will not grow and Asian exports will suffer.
The speed of some of the market movements began to trigger suspicion of speculative attacks, particularly on the euro, which fell to its lowest in eight months. At $1.363 on February 5, it was 4 cents off its February 3 peak?a huge shift in the foreign exchange world for the second most-traded currency (chart 2).
The sharp movements also illustrate what many market watchers now call shoal trading?after its similarity to fish shoals that zip in a single direction until a movement by one causes them all to change course together. Such movements were being exacerbated by exchange-traded funds and other tracking instruments, which adjust their holdings of an asset depending on its value. It?s happening more and more in the markets with an ever bigger impact.
Strategists are also talking about a return of so-called bond vigilantism, whereby investors? selling of government bonds is interpreted as a direct criticism of expansionist government policy. In India, 10-year bond yields have shot up to nearly 8%, and bond prices have fallen sharply. Concerns about whether the forthcoming Union Budget 2010 will be able to rein in the ballooning fiscal deficit are adding to the anxieties of bond investors.
Various governments have been focusing on measures to stimulate the economy rather than talking about how they will unwind?and pay for?last year?s emergency stimulus. With markets so jittery about sovereign risk, the populist pro-growth focus has unnerved bondholders. Perhaps the biggest sign of the removal of risk was the fall in the price of gold, which lost almost $50 on February 4 alone. Last year its rally was considered unusual given the appetite for risk. This year, investors? desire to derisk seems equally indiscriminate?what went up must now come down.
Oil and metals, currencies of commodity exporters and emerging market stocks were all part of essentially the same bet last year. They reinforced each other on the way up and once US and European investors lost their nerve, they all fell down in unison.
In chart 3, I have plotted the volatility in US stock prices and the exchange rate of the Brazilian real vis-?-vis the US dollar. The Brazilian real is a classic way of playing the belief that growth in emerging markets will lead the commodities higher and also the decoupling of emerging markets from the developed world. It almost seems like the stock market rally last year was driven in substantial measure by changed sentiment in the West, rather than entirely by improved fundamentals of the emerging world.
Oil, which fell by more than $100 per barrel from a peak close to $150, has touched a post-crisis high of $82.50 (although it has retreated to $75 at the time of writing this article)?a level that, when it was first reached in 2007, seemed to presage stagflation.
Carry trade currencies, with interest rates buoyed by high commodity prices, are moving in line with such prices. The Australian dollar, which fell by 20% against the yen in the first hectic week of October 2008, is also at a post-crisis high. Oil price and carry trade seem to be moving quite closely (illustrated in chart 4), which seems to suggest that the price of oil has moved more with speculation than simply in line with the fundamentals.
The key is the pattern of market behaviour. As in previous sell-offs, all risky assets, including stocks, emerging markets, commodities and the euro have suffered together, while the dollar strengthened and Treasuries and German bonds rallied, a classic flight to quality. This points to the same underlying trade that has been playing out since the start of the crisis: a virtually binary switch between risk appetite and risk aversion.
Take the sharp decline in the euro versus the dollar. This may partially reflect concerns about the eurozone?s credibility, but it is also being driven by flows into the dollar as carry trades are unwound. If there were real doubts about the eurozone, then the euro would be expected to fall against the Swedish or Norwegian currencies. But this isn?t happening.
The author is a Wharton Business School MBA and CEO, Global Money Investor