Ripple Effects Agitate Markets
A few things investors have learned, or relearned, from the tumult in global markets in the last five weeks:
* The level of dangerous speculation in financial assets never is fully apparent until fear trumps greed. Then, everyone is “shocked, shocked to find that gambling is going on in here!”
* The U.S. remains the 800-pound gorilla of world markets. The rest of them can go their own ways when Wall Street is placid or limping along, but when it’s agitated, nearly every market is going to feel Kong’s pain.
* It is possible for the Federal Reserve to talk too much.
By now, everyone knows that stock prices have slumped almost everywhere on the globe since mid-May.
The boilerplate explanation is that investors suddenly became nervous that rising inflation pressures would drive the Fed and other central banks to continue tightening credit, perhaps to the point where they would choke off the strongest global economic expansion since the early 1970s.
“When you get inflation accelerating, the Fed always risks overshooting,” says Ethan Harris, an economist at brokerage Lehman Bros. in New York. “The Fed doesn’t like to create recessions, but accidents happen.”
That may have been the root cause of the markets’ slide, but it’s a stretch to think that a lot of investors took time to connect the dots. Heavy selling of stocks often is little more than a function of itself: Once it starts in volume, it causes more of the same.
Let’s assume, though, that the markets were seized by a generalized fear sparked by the Fed’s tougher talk on inflation, beginning in early May.
In congressional testimony April 27, Fed Chairman Ben S. Bernanke suggested that the central bank might soon pause in raising short-term rates after nearly two years of consistent increases.
Then Bernanke reconsidered. On May 10, when Fed policymakers met, they raised their benchmark rate yet again, and warned that they might keep going. On May 17, when the government reported a surprisingly big jump in April consumer prices, talk of a pause all but died.
Since then, central banks in Europe, Turkey, South Korea and India, among others, also have raised interest rates.
Higher rates pose two big problems for stocks: They’re competition for capital. And they make it tougher for an economy to keep growing. Either way, higher rates raise the risk in holding stocks.
So what some investors chose to do in the last five weeks was to reduce their risk level by selling equities. It was a logical move.
And not surprisingly, the stock sectors that went up the most during the last few years -- emerging markets, for example, and commodity-related issues -- came down the fastest, because those were bets on robust global growth, and because that was where people had the biggest profits to protect.
Those sectors also tumbled because some of the players recognized that what they were doing was as much rank speculation as investing, if not more so. Why did they buy? Because it was going up!
Speculative money is by definition hot money, but it often masquerades as responsible capital -- until it gets frightened.
Hot money also can be problematic because it sometimes is borrowed money. Investors can buy stocks on credit through so-called margin accounts at brokerages. Buying on credit compounds your winnings when stocks are rising. When they go the other way, however, the use of debt means your losses are compounded. That can fuel a cascade of selling in falling markets, as some investors who bought on margin are forced to cash out to stem their losses.
Investors’ margin debt balances at New York Stock Exchange member brokerages reached $241.5 billion in April, the latest month for which data are available. The total has been climbing with the bull market of the last three years and is nearing the record $278.5 billion of March 2000, at the height of the technology-stock frenzy of that era.
That may help explain the ferocity of the slide in some market sectors in the last five weeks, as selling begot more selling. Again, the Fed may only have been an afterthought for many of those investors.
Hot money also was having a field day this year in many emerging markets, whose stock charts began to look a lot like those of the rocketing dot-coms of early 2000.
For some fans of booming emerging economies such as Russia and India, a popular school of thought was that business was so good, and the outlook was so strong, that money wouldn’t want to leave local stocks. Even if U.S. stocks wilted, the thinking went, capital would stay in foreign markets because the long-term growth potential was so stellar.
But the gravitational pull of the U.S. economy, and its markets, once again proved too powerful. This still is the largest economy on Earth, and it’s populated by the world’s best shoppers, a huge source of global demand. Investors in foreign markets simply could not ignore the ominous signals from Wall Street in mid-May as stocks began to slide.
The last five weeks suggest that a sustained market decline here probably would mean much the same everywhere else -- and probably something worse in the many markets that have far outperformed U.S. shares in recent years. That’s already true in places such as Russia, where the market is down 25% from its May peak. India’s market is down 22% from its May high.
Yet it’s too early to say that the bull market that began in October 2002 is over. U.S. stocks rallied briskly Wednesday and Thursday, before stalling out again Friday.
As painful as the losses have been this spring in some U.S. market sectors -- particularly small-company issues -- they remain within the 10% to 15% range of a garden-variety “correction” in a bull market.
The blue-chip Standard & Poor’s 500 index never even got to the 10% threshold, nor did the Dow Jones industrial average. At 11,014.55 on Friday, the Dow was down 5.4% from its six-year high reached May 10.
As Edward Yardeni, strategist at money manager Oak Associates in Akron, Ohio, puts it: “While the global sell-off in stocks and commodities has been reminiscent of previous financial crises and contagions, nothing really terrible has actually happened. Investors and speculators have lost lots of money, but most of it was their gains just since the start of this year.”
And although a Fed rate hike from 5% to 5.25% now is a virtual certainty at the central bank’s June 28-29 meeting, that might not be the end of the world, or even of the economic expansion.
But how much higher will they go? Where will inflation peak? That uncertainty will remain after the next Fed meeting, which at a minimum probably will make for a volatile summer in markets -- fun for hard-core traders, maybe, but off-putting for everyone else.
Odds are that Fed policymakers, and their counterparts overseas, will stay obsessed with inflation risks, for better or worse. And they clearly want their obsession to be our obsession, because they can’t stop talking about inflation.
Twenty years ago, the Fed was as talkative as the Sphinx. Now, its governors and regional bank presidents can’t seem to shut up. They’re in investors’ faces every day, via newspapers, TV and the Internet, yammering about inflation.
“One part of the story is the Fed is talking too much about inflation,” says David Kelly, economic advisor at Putnam Investments in Boston. “The other part is that people are listening too much to the Fed.”
If they’re trying to scare the markets, it’s working. If they’re trying to be transparent and helpful, they may need to reconsider.
Inflation is bad -- we get it, already. Can we talk about something else?
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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit latimes.com/petruno.
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Leveraged up
Investors have ramped up their borrowing against investment accounts in recent years, a factor that may have helped worsen the recnet stock sell-off.
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