By ROBERT HARLEY 16/06/2006
Even with the distraction of summer sunshine and the World Cup, it's been hard to ignore the high stockmarket volatility of the last few weeks.
While, in our view, there is no need to panic, it is important to review the influences behind the recent market falls.
| "One of the key drivers appears to have been a global liquidity squeeze ." |
Markets are affected by a complex web of different factors, so it's naïve to pinpoint a sole reason for the recent downturn and increased volatility. However, one of the key drivers appears to have been a global liquidity squeeze, i.e. there's less money flowing around global economies. This has occurred thanks to Central Banks raising interest rates and/or reducing money supply in reaction to fears that rising inflation is a major threat to the world economy. One of the most prominent examples has been Japan. Having significantly increased money supply over recent years in a bid to defeat 18 years of deflation, the Bank of Japan has now slashed money supply by 15% as the Japanese economy has started to breathe again. While this may well keep inflationary pressures in check, it's a rather heavy handed approach which has no doubt contributed towards market jitters.
Progressively raising interest rates is a less aggressive alternative and a route that many Central Banks have adopted in fear that, left unchecked, inflation might accelerate uncontrollably. However there are concerns that Central Banks are raising rates too quickly, running the risk of pushing global economies into recession. It can take many months for interest rate changes to impact on an economy, so has, for example, the Federal Reserve been over zealous in raising interest rates seven times during the last year? (from 3% in May 2005 to the current 5%). Markets, it seems, are worried it may have been.
A knock-on effect of reduced liquidity has been falling commodity prices. This is not surprising; if there's less money available for spending then prices typically fall to maintain the demand/supply status quo. Given the meteoric rise in commodity prices over the last few years, commodities were a prime candidate for a fall. In spite of high short term volatility, commodities may prove a resilient sector medium term. Prices are still close to their lowest in real terms for 200 years and the seemingly insatiable demand from emerging economies would have to fall off a cliff for there to be a fundamental demand shortage. It also seems that analysts reviewing commodity producers tend to be basing their projections on commodity prices well below current levels, so in theory share prices could ultimately absorb the recent setback (although this is unlikely to stop volatility short term).
| "Reduced liquidity has also led to forced selling ." |
Reduced liquidity has also led to forced selling, as some speculators have had to unwind their positions. When interest rates were very low (zero in Japan!) borrowing to fund investment ('leveraging') appeared very attractive. However as rates have risen (and the Japanese Yen has strengthened) the costs of borrowing have, for some investors, become prohibitive. These speculators have increasingly been dumping positions as they try to avoid getting their fingers burned, which has undoubtedly added to stockmarket volatility. It's likely there's more of this to come.
We believe that another two or three months of stockmarket turbulence could convince the more sensible Central Banks that they've gone too far. The upshot will likely be steady, or even falling, interest rates which should have a calming effect on stockmarkets. The fact that many companies continue to record healthy profits and are sitting on piles of cash also provides some comfort; we are certainly not experiencing a period where the stockmarket is plagued with unrealistic sky-high company valuations.
While it would be foolish to expect markets to continue racing ahead over the next three years, the outlook does not appear as grim as the recent setback suggests. However, market jitters could continue throughout the summer, so we're not out of the thick of the woods yet.