Monday, 29 May 2006

Stock markets fall from rising risk aversion

The fall in global stock prices over the past two and a half weeks has widely been attributed to fears of higher interest rates. However, with emerging markets suffering somewhat more than developed markets during the recent sell-off, rising risk aversion is clearly an important factor too.

According to data from Dow Jones, world equity markets fell from 10 May to 26 May. Developed markets fell 5.5 percent during this period but emerging markets fell 11.4 percent, twice as much.

In a special report today in The Straits Times on the turmoil in emerging stock markets, Ravi Velloor asks: "Why did this happen?" His answer: "Top of the list is the fear of rising interest rates, particularly in the US."

"Driven by that fear of higher interest rates in the US and other key markets such as Germany and Japan, the world's biggest investors simply decided to park their money in assets regarded as less risky, even if that meant sacrificing some returns."

Less risky assets includes US Treasuries. Ironically, however, if investors park more money in such assets, their interest rates would go down.

As it turns out, over the period 10-26 May when stocks fell, yields on 10-year US Treasuries did fall by seven basis points. So if markets fear higher interest rates, it is only at the short end of the yield curve. Over longer time horizons, markets appear more concerned about risk than about interest rates.

That could be because inflation fears actually receded during this period. The recent falls in stock prices was accompanied by falls in the prices of commodities.

In another article in the same report in The Straits Times, Chua Kong Ho provides another perspective on the recent market turmoil: "Market watchers say the market slump was the result of a rapid climb in share prices that 'over-shot' fair value -- so the market slump simply represented a return to realistic levels. The trigger: fears of rising US inflation and uncertainty whether the US Federal Reserve will keep raising benchmark interest rates."

Yet another writer, Erica Tay, writes in The Straits Times today: "[F]inancial markets have been awash with so much cash that investors have bought assets indiscriminately, pricing risks too low.

"With the Big Three central banks of the US, the euro zone and Japan all in tightening mode for the first time in 15 years, the end of easy money translates into greater sensitivity to risk -- a bane for emerging economies."

So greater uncertainty and risk aversion has been a significant factor behind the fall in stock markets, especially in emerging markets. Or as Tay's article quoted Selena Ling, an economist at OCBC Bank, as saying of the market: "The mood just turned."

There is certainly greater uncertainty now than in the past couple of years. Whereas the Federal Reserve had been on a steady path of measured rates hikes in the latter half of 2004 and in 2005, it has since declared that it is now data-dependent, leaving markets with more uncertainty over the path of Federal Reserve action in the near future and therefore greater risk in pricing assets.

Furthermore, the European Central Bank and the Bank of Japan, which had left interest rates unchanged for much of the last few years, have both started moves towards tightening of monetary policy. Unlike the rate hikes by the Federal Reserve in 2004 and 2005, however, the ECB has been hiking rates in stop-start fashion, while the BoJ has been battling politicians as it implements its plan to remove liquidity even as data show the Japanese economy to be barely out of deflation.

Compared to the past few years, such a situation leaves markets relatively uncertain over the future direction of monetary policy in these economies. Effectively, the ECB and the BoJ are injecting fluidity to market conditions even as they remove liquidity.

However, if stock markets are falling as central banks are tightening, this would hardly be the first time. If markets are re-pricing risk only now, as Tay suggests, then they might have been too complacent. After all central banks have always had to tighten as the economic expansion matures and threatens to cause overheating.

As Ling, the economist cited in Tay's article, points out: "Raising interest rates is, from an economist's point of view, the solution, not the problem."

Indeed, from an economist's point of view, one should probably ask whether interest rates should have been raised faster or sooner in some of the more strongly-expanding economies. That might have damped some of the risk appetite earlier and saved investors from the current anxieties.

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