Nerves are rattled. Tempers are fraying. The eyebrows are furrowed. Grins turned into grimaces and are likely to be replaced by permanent scowls. No, I am not anticipating the state of the Indian cricket fan after the World Cup tournament. It is about the financial investor, at the end of a baffling week in global financial markets.
What is interesting is that it was triggered by the man who warned of irrational exuberance and then hastily amended it, 10 years ago.
Speaking in a conference in Hong Kong via satellite, Alan Greenspan, former chairman of the US Federal Reserve, said that the US economy could face a recession in the second half of the year. He corrected himself subsequently. It was always possible for an economy in its sixth year of expansion to have a recession but it did not appear probable, he said. The damage appeared done. Chinese stock indices crashed 9% last Tuesday. Some people said that China had become the centre of the financial market universe. This comment was both frivolous and silly.
When asset prices begin to revert, this starts in more egregiously valued markets. Readers should remember that Indian equities had begun to correct some time ago—before China.
Therefore, the argument that the recent correction began in China does not hold. And, the fall in China’s indices is no indication of its overriding importance to the world, but a signal that its markets were well into bubble territory. Moreover, positive US equity markets constitute a necessary but not a sufficient condition for emerging market equities to advance. That is, one can have big declines in emerging markets without the US participating. However, when the US begins to correct, there are no hiding places.
The question is how serious and sustained this correction would be. The answers are centred in the US housing market and in the fortunes of the yen. First, the issue is whether the rise in US home prices is about to reverse and, in the process, lead to increased defaults by mortgage borrowers and to closures among lending institutions. Twenty financial institutions which lend to low-creditworthy (“sub-prime”) borrowers have shut down in recent months. In addition, the Securities and Exchange Commission claims to have busted an insider trading ring in Wall Street that involved traders in Wall Street brokers and their hedge-fund clients.
Beneath these disturbing revelations, the fundamentals appear to be holding up. The median price of a home in the US rose 1% in the fourth quarter. The economy’s growth rate has slowed but is still positive. Consumers report that jobs are easier to find and most home builders are reporting that demand has stabilized. Inventories are being worked off by manufacturers and new orders received by manufacturers in the US, net of inventory accumulation with their consumers, are rising—this is a sign of healthy demand in the economy. There appears to be no economy-wide spillover from the woes of some borrowers and lenders.
The other risk is the unwinding of the yen carry-trade. In simple terms, given near-zero interest rates in Japan, it has been a child’s play for borrowers to borrow in yen and deploy the money for productive or speculative purposes in search of higher yields.
Japanese investors too are in the thick and thin of it. This has been going on for such a long period of time that it is almost impossible to quantify the amount of yen-denominated borrowings. The yen price of the US dollar has dropped 4.7% from its peak this year. Most of the advantage of carry-trade has been wiped out and is in the negative, if this decline is annualized.
Back in 1998, between mid-August and mid-October, the yen strengthened by more than 22%. That was not due to Japanese interest rates going up. Interest rates actually declined during the period. Hence, that was not the trigger then and that is unlikely to be a trigger for further yen gains now. Nonetheless, the yen strengthened significantly in 1998, as risk aversion climbed. Shortly thereafter, a big hedge fund collapsed. History does not have to repeat, let alone rhyme. Then, there were solid reasons for risk aversion to return. Asia was in crisis and Russia had defaulted. There is no such headwind now.
Hence, the return of volatility and fear of risk—welcome as they are—are unlikely to be as pervasive and deep as they were in 1998. If this prognosis is correct, then the current phase of volatility in global financial markets should end fairly soon. These could turn out to be famous last words because there is one big caveat: we simply do not know the skeletons hidden in the portfolios of hedge funds and their brokers. If their payback time has come, then all bets are off.
V. Anantha Nageswaran is head, investment research at Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Comments are welcome at firstname.lastname@example.org