The financial markets: Surprised by the expected
The recent downturn in financial markets provides a classic example of the expected happening at an unexpected time. Many financial analysts felt that a "correction" would happen at some point. Few, though, would have managed to predict the recent events.
The recent downturn in financial markets provides a classic example of the expected happening at an unexpected time. Many financial analysts felt that a "correction" would happen at some point. Few, though, would have managed to predict the recent events. Even if they had guessed correctly which markets would suffer, not many would have been lucky enough to get their timing right as well.
When stock markets fall, people look for explanations. Among the favourites this time around were rumours of more stringent controls on the Shanghai stock exchange (the stock market falls began in China), a deterioration in US economic data, and, to cap it all, masterful words from the world's leading octogenarian economic sage. Alan Greenspan, former chairman of the US Federal Reserve, warned that the US might find itself in recession by the end of the year.
To be fair, there are genuine reasons to be concerned about the US economy. At the turn of the year, US economic data mostly surprised on the upside. Recently, though, disappointment has set in. The housing market has shown renewed signs of weakness. Durable goods orders have collapsed, suggesting that companies, despite their buoyant profits, are struggling to find worthwhile investment projects. Problems in the sub-prime market have led banks to tighten up their lending practices to households and the labour market is not as strong as it was.
US economic difficulties, however, only really became clear after the Chinese stock market had already taken a tumble. While it is possible to argue that uncertainties about the US economy may have contributed to the size of the market sell-off, it is a lot more difficult to make the case that the recent US slowdown was the underlying cause.
It seems that most investors had been waiting for a moment such as this. Many have taken the view that there is simply too much "liquidity" sloshing around the system, a factor that apparently explains why all manner of asset prices have risen rapidly in recent times. Seemingly, anything with a yield or prospective capital gain is worth buying. Faced with a lot of cash, investors can choose to invest in anything, that is, other than cash itself.
However, if someone comes along and turns the cash spigot off, the whole story is in danger of going into reverse. Investors suddenly realise they have to exercise a greater degree of discretion. They have to be more selective over the assets they choose to buy. They become more risk-averse.
"Liquidity" on the other hand is a rather unsatisfactory concept. For some, liquidity results from overly loose monetary conditions. Central banks set interest rates at too low a level, encouraging a borrowing and investing spree. For others, liquidity comes from central bank intervention.
There may be some truth in these claims. They are, though, not fully convincing. Equity prices have made strong gains in recent years, but those gains have come against a background of persistently rising short-term interest rates from the US Federal Reserve. Monetary conditions may not necessarily be tight, but they are certainly not as loose as they used to be. Meanwhile, emerging market central banks are not the only source of excess "liquidity".
To better understand, it is worth thinking about why fund managers seem to be absolutely awash with cash at the moment. Emerging market central banks certainly play a role, but there is another important factor. The vast majority of companies are very profitable, yet at the same time have no particular desire to invest these profits back into their businesses. They are not convinced - and, on many occasions, neither are their shareholders that extra capital spending is really required. In the US, for example, capital spending fell in the final quarter of last year, and the latest durable goods orders indicate further weakness to come. If companies have plenty of money but have no desire to invest, they return their profits to the shareholder, either in the form of higher dividends or share buybacks. The shareholders, in turn, find themselves awash with cash that now needs to be invested somewhere else.
Put another way, an absence of investment in physical machinery leads to an excess of investment in financial (and real estate) assets. Prices of these assets are bid too high, and eventually the smallest of shocks can upset the apple cart. The vulnerabilities exposed over the last few weeks are not so much the result of Chinese stock market regulations or the wise words of a monetary wizard, but rather a reflection of the longer-term shifts in savings behaviour by both companies and emerging market central banks.
The liquidity story is only good while it lasts. So long as each investor believes that every other investor is being almost compelled to buy a wide range of assets because of the inflows of cash, then each investor, individually, will be happy to do the same.
Moreover, each investor can pretend the risks are low because he or she believes that every other investor knows about the underlying risks and is pricing assets accordingly. However, if everyone is buying assets no matter what, it is difficult to argue that risk really is being priced correctly.
What sorts of things might lead to a re-pricing of risk and, perhaps, a more extended period of asset price weakness? This might result from emerging market central banks choosing to sell US dollars, undermining the world's reserve currency or from a weakness in the US housing market that might eventually feed through to the rest of the US economy, undermining corporate profits.
Currently, though, many investors regard Japan as being one of the most important sources of global "liquidity". After all, investors are able to borrow cheaply in yen and reinvest the proceeds elsewhere. Should the Bank of Japan raise interest rates a lot further, this particular source of liquidity would be closed off. Many see the yen's recent rally as the beginning of this process. However, heightened risk aversion reduces the willingness of investors to indulge in this particular "carry trade". It is the vulnerability of investors' animal spirits not the actions of central bankers, that is leading to this renewed bout of market volatility. However, investors' spirits are vulnerable because they know that the good times will not last.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
When stock markets fall, people look for explanations. Among the favourites this time around were rumours of more stringent controls on the Shanghai stock exchange (the stock market falls began in China), a deterioration in US economic data, and, to cap it all, masterful words from the world's leading octogenarian economic sage. Alan Greenspan, former chairman of the US Federal Reserve, warned that the US might find itself in recession by the end of the year.
To be fair, there are genuine reasons to be concerned about the US economy. At the turn of the year, US economic data mostly surprised on the upside. Recently, though, disappointment has set in. The housing market has shown renewed signs of weakness. Durable goods orders have collapsed, suggesting that companies, despite their buoyant profits, are struggling to find worthwhile investment projects. Problems in the sub-prime market have led banks to tighten up their lending practices to households and the labour market is not as strong as it was.
US economic difficulties, however, only really became clear after the Chinese stock market had already taken a tumble. While it is possible to argue that uncertainties about the US economy may have contributed to the size of the market sell-off, it is a lot more difficult to make the case that the recent US slowdown was the underlying cause.
It seems that most investors had been waiting for a moment such as this. Many have taken the view that there is simply too much "liquidity" sloshing around the system, a factor that apparently explains why all manner of asset prices have risen rapidly in recent times. Seemingly, anything with a yield or prospective capital gain is worth buying. Faced with a lot of cash, investors can choose to invest in anything, that is, other than cash itself.
However, if someone comes along and turns the cash spigot off, the whole story is in danger of going into reverse. Investors suddenly realise they have to exercise a greater degree of discretion. They have to be more selective over the assets they choose to buy. They become more risk-averse.
"Liquidity" on the other hand is a rather unsatisfactory concept. For some, liquidity results from overly loose monetary conditions. Central banks set interest rates at too low a level, encouraging a borrowing and investing spree. For others, liquidity comes from central bank intervention.
There may be some truth in these claims. They are, though, not fully convincing. Equity prices have made strong gains in recent years, but those gains have come against a background of persistently rising short-term interest rates from the US Federal Reserve. Monetary conditions may not necessarily be tight, but they are certainly not as loose as they used to be. Meanwhile, emerging market central banks are not the only source of excess "liquidity".
To better understand, it is worth thinking about why fund managers seem to be absolutely awash with cash at the moment. Emerging market central banks certainly play a role, but there is another important factor. The vast majority of companies are very profitable, yet at the same time have no particular desire to invest these profits back into their businesses. They are not convinced - and, on many occasions, neither are their shareholders that extra capital spending is really required. In the US, for example, capital spending fell in the final quarter of last year, and the latest durable goods orders indicate further weakness to come. If companies have plenty of money but have no desire to invest, they return their profits to the shareholder, either in the form of higher dividends or share buybacks. The shareholders, in turn, find themselves awash with cash that now needs to be invested somewhere else.
Put another way, an absence of investment in physical machinery leads to an excess of investment in financial (and real estate) assets. Prices of these assets are bid too high, and eventually the smallest of shocks can upset the apple cart. The vulnerabilities exposed over the last few weeks are not so much the result of Chinese stock market regulations or the wise words of a monetary wizard, but rather a reflection of the longer-term shifts in savings behaviour by both companies and emerging market central banks.
The liquidity story is only good while it lasts. So long as each investor believes that every other investor is being almost compelled to buy a wide range of assets because of the inflows of cash, then each investor, individually, will be happy to do the same.
Moreover, each investor can pretend the risks are low because he or she believes that every other investor knows about the underlying risks and is pricing assets accordingly. However, if everyone is buying assets no matter what, it is difficult to argue that risk really is being priced correctly.
What sorts of things might lead to a re-pricing of risk and, perhaps, a more extended period of asset price weakness? This might result from emerging market central banks choosing to sell US dollars, undermining the world's reserve currency or from a weakness in the US housing market that might eventually feed through to the rest of the US economy, undermining corporate profits.
Currently, though, many investors regard Japan as being one of the most important sources of global "liquidity". After all, investors are able to borrow cheaply in yen and reinvest the proceeds elsewhere. Should the Bank of Japan raise interest rates a lot further, this particular source of liquidity would be closed off. Many see the yen's recent rally as the beginning of this process. However, heightened risk aversion reduces the willingness of investors to indulge in this particular "carry trade". It is the vulnerability of investors' animal spirits not the actions of central bankers, that is leading to this renewed bout of market volatility. However, investors' spirits are vulnerable because they know that the good times will not last.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.