Stock markets around the world fell last week fell as concerns increased that China will try to cool its economy and the president of the United States proposed steps to limit risk-taking by banks.
Over the past week, China added to signs that it was throttling back stimulative measures initiated during the financial crisis.
After raising the reserve requirement of banks by 50 basis points the previous week, the People's Bank of China guided up yields on its bills again last week. It raised the auction yield on its one-year bills by 8 bps to 1.9264 percent on Tuesday and its three-month bills by about 4 basis points to 1.4088 percent on Thursday.
On Wednesday, chairman of the China Banking Regulatory Commission Liu Mingkang said in an interview that some lenders had been asked to rein in credit because they had failed to meet regulatory requirements.
Expectation of further tightening by Chinese policy makers were also raised on Thursday when China reported that its economy accelerated to 10.7 percent growth in the fourth quarter. Concern was exacerbated by the fact that inflation also accelerated, hitting 1.9 percent in December.
However, while events in China almost certainly influenced global markets, they would not have been enough to make such a large impact if not for coincident market-unfriendly developments in the US.
On Thursday, President Barack Obama presented a proposal that would limit the size of banks and prohibit them from owning, investing in, or sponsoring hedge funds, private equity funds, or proprietary trading operations for their own profit. Coming on the back of another proposal on 14 January to tax large financial firms, Wall Street is understandably becoming increasingly nervous about the political and regulatory climate in the US.
And to make matters worse, there is a risk that Wall Street may lose an important ally of sorts.
While the Federal Reserve had uncharacteristically taken a back seat in the midst of these market-moving events, it became a centre of attention again on Friday when some US Democratic Party senators voiced reservations about Ben Bernanke’s re-appointment as chairman. The uncertainty this engendered weighed on markets on Friday. The possibility of the market losing one perceived source of support -- the so-called Bernanke put, whereby the Fed allows asset bubbles to run but steps in to stop market crashes -- also did not help.
In the face of these developments, some investors decided to dump stocks.
In the US, the S&P 500 fell 3.9 percent to 1,091.76 last week, its biggest drop since October. Over the last three trading days of the week, the S&P 500 lost 5.1 percent.
Over the week, the Dow Jones Industrial Average fell 436.67 points, or 4.1 percent, to 10,172.98. The Nasdaq Composite Index decreased 3.6 percent to 2,205.29.
In Europe, the Dow Jones Stoxx 600 Index fell 2.6 percent to 249.91 last week, also the sharpest weekly drop since October. National benchmark indices fell in all 18 western European markets. The FTSE 100 fell by 2.8 percent, the DAX by 3.1 percent and the CAC 40 by 3.4 percent.
In Asia, the MSCI Asia Pacific Index fell 3.5 percent to 122.39 last week. The Nikkei 225 Stock Average declined 3.6 percent, the Hang Seng Index lost 4.3 percent and the Shanghai Composite Index dropped 3.0 percent.
Most of the above indices are now in the red for the year.
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Markets have clearly lost their bullish momentum. Less clear is what the latest bout of market weakness means for stocks in the next few months.
While it is quite obvious that the tightening trend in China is negative for stocks, it is not clear that it will be enough to derail the bull run in stocks. Bull markets usually survive early central bank tightening. Meanwhile, other major central banks like the Federal Reserve and the European Central Bank are very unlikely to raise interest rates anytime soon.
On the US political front, President Obama's plan to place restrictions on banks still lacks details and there are doubts as to whether it will be passed by Congress. Meanwhile, Bernanke's re-appointment as Fed chairman has become a little more secure after expressions of support for him from several senators over the weekend.
Still, the events of the past week remind us that with the global economic recovery still fragile, stock markets are vulnerable to shifts in policy around the world.