Summer in the city could be more than sticky By Philip Coggan

Summer in the city could be more than sticky
By Philip Coggan
Published: May 20 2006 03:00 | Last updated: May 20 2006 03:00. Copyright by The Financial Times

Something DID give. When I suggested last week that the buoyancy of asset markets could not be sustained, I did not expect to be proved right quite so soon.

But a downturn was inevitable for a number of reasons. The first was that a climate of fast-rising commodity prices, buoyant equity markets, relatively stable bond markets and tighter global monetary policy was inherently unstable. Investors would have to start worrying about inflation or growth.

The second issue was that the equity market had risen for more than three years without a correction (defined as a fall of more than 10 per cent). This was unusual, as was the low level of volatility in the equity markets.

There are a number of potential explanations for the shift but let us start with a description, more than an explanation; investors became more risk-averse. We can see that by looking at the kind of assets that sustained the most damage: commodities, emerging market currencies, such as the Turkish lira, and small cap indices, such as the FTSE 250 in the UK. Risky asset categories tend to be illiquid which exacerbates the effect of investor sales.

What caused this risk aversion? One theory is that investors have become more worried about inflation; but over the week since the start of the move, gold has fallen and Treasury bond yields are virtually unchanged.

Another theory is that the markets have lost confidence in the Federal Reserve under new chairman Ben Bernanke. But that does not explain why the dollar has barely moved against the yen or euro over the last week.

It would be more plausible to argue that Treasury bonds had benefited from their "safe haven" status as investors moved out of equities and commodities. Meanwhile gold, instead of being a safe haven, has in recent weeks been simply a vehicle for speculation.

If investors are buying on the basis of momentum (that what is rising in price will continue to do so), then any change in trend will send them heading for the exits.

The derivatives market may also be an important influence. The details are fiendishly complicated but the essence is that some investors have bet on volatility staying low. As volatility has increased, they have been forced to hedge their positions, using strategies that have only increased the scale of market falls. Historically, volatility has tended to occur in clusters.

This column takes the "long view" and what is important for investors is whether this current turmoil will be extended. On that note, it is interesting that the Dow Jones industrial average has retreated before passing its all-time high; creating the possibility that we are still in a rally in a bear market, rather than a new bull market.

There are currently two all-encompassing views of the future of the global economy and financial markets. Both are plausible. Alas, they disagree violently. The recent market turmoil suggests the assumptions behind those views are being put to the test.

This week, Peter Oppenheimer of Goldman Sachs produced an excellent summary of the bullish case, albeit with the ugly title of Globology. His argument is that the opening-up of the global economy resembles the industrial revolution; it is producing a sustained rise in the economic growth rate without inflationary pressures.

A 25 per cent jump in the global labour force since 1990 (as ex-communist countries become part of the global economy) has shifted the balance of power in favour of the corporate sector and away from labour. The emergence of low-cost centres of production has slashed the prices of manufactured goods.

At the same time, the widespread use of technology has enabled companies to run their businesses much more efficiently.

All this has allowed profits to rise to a high level of gross domestic product (following a big dip after the bursting of the dotcom bubble). This level of profitability, believes Oppenheimer, can be sustained. Companies in the west have outsourced production (a significant source of volatility) to Asia. But the big rise in exports has allowed Asian countries to build up foreign exchange reserves, reducing the volatility of their economies.

A world of stronger growth, low inflation and less volatility should be very good news for risky assets. Those who took this view naturally had a positive outlook for equities.

The bears would dismiss these arguments as the classic "it's different this time" rationalisation of the bulls. If profits are at a high, relative to GDP, that is a cyclical phenomenon. That should mean that investors give equities a lower valuation than average, as future profits growth is likely to be slower than GDP.

The bears argue that the sharp rise in asset prices is simply a function of loose monetary policy. A bear such as Marc Faber also argues that the US inflation rate is understated and the real rate is running at 5-6 per cent.

The rise in US core inflation, announced this week, will convince the inflation worriers they are on the right track. Whether things will become quite as apocalyptic as they suggest is hard to tell. But one thing does seem clear. The rosy assumptions of the optimistic school have come under question. The trade-off between growth and inflation may not be as good as they suggest.

Unless and until the data start to look benign again, investors may face a very tricky and very volatile summer.

philip.coggan@ft.com