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Risk, the economy and markets

2011-03-17 08:07:04

A flight from risk

Mar 15th 2011, 13:15 by Buttonwood

WHEN troubles come, they come not as single spies but in battalions. The

markets have suffered from a series of blows in the last few weeks that have

derailed the stockmarket rally. We are merely halfway through March, and two

events that were on few people's radar screens for 2011 - middle east political

turmoil and the terrible Japanese earthquake/tsunami are dominating the

headlines. It has not helped that investors were overconfident a month or so

ago; a Bank of America Merrill Lynch survey of fund managers found that a net

67% were overweight equities in February.

The normal rule with natural disasters is that, terrible as they are in their

toll of human life, the markets tend to over-react. The initial hit to economic

activity is followed by a rebound in later quarters as reconstruction occurs;

there is a hit to the national stock of wealth, of course, but as that is

imprecisely measured, investors tend to take less notice. This time round,

however, the continuing crisis at the Fukushima nuclear plant, is adding to the

uncertainty. I have lost count of the number of experts who have come to the

BBC to say that "the situation is under control", only to be interrupted by

news of an explosion, fire or radiation leak.

For international economies, there are a number of risks here. There is the

cost to global reinsurers from the destruction; there is the risk that Japanese

investors need to repatriate assets to meet the bill; there is the disruption

to supply chains with Japanese factories being forced to close; and there is

the risk that this will be the last straw for the Japanese bond markets.

Markets have reacted by doing what they normally do when caught by surprise;

cutting their most exposed positions. Thus the currency that has suffered the

biggest hit since Friday is the Australian dollar. The Aussie had been riding

high as a way of playing strong commodity markets; with commodity prices off

the boil, investors have cut their positions.

Oil is down 3.5% and natural gas down 2.2% on the news. But the nuclear

incident is likely to reduce, or at the very least delay, the demand for

nuclear power in many parts of the world, leaving oil and gas as obvious

beneficiaries. And the middle east is still in turmoil; on a normal day, the

move of Saudi Arabian troops into Bahrain would have grabbed the headlines

while the Libyan civil war goes on, raising the prospect of western military

intervention.

That is five paragraphs of bad news, and I haven't yet had time to mention the

prospect of a rate rise from the European Central Bank or that the package

announced by EU leaders last weekend did not really deal with the fiscal

crisis. And there is the uncertain impact of Chinese policy tightening on

global growth.

The ECB rate rise is a sign of the dilemma facing central banks; higher

commodity prices push up the headline inflation rate while representing a

squeeze on demand. Do they let inflation exceed its target at the risk of a

loss of credibility? Or do they tighten policy and risk derailing the recovery?

The poll of fund managers, out today, found that many fear below-trend growth

and above-trend inflation, the worst possible combination.

In America, I pointed out the inflation pressures signalled in the ISM

yesterday, a factor that is confirmed in today's Empire State survey and import

price numbers. Alan Ruskin of the Royal Bank of Scotland comments today that

The import price data (show) another large 0.7% gain in manufactured goods

imports, and another large increase in import prices from China (0.4%) and

Japan (0.5%). The import price pressures have now assumed a consistency that

has become a trend and is tending to strongly reinforce an impression that

disinflationary forces from the emerging world are drawing to an end. In many

respects this is a giant circle, with the US exporting easy monetary policy to

the rest of the world and emerging manufacturers are now starting to export

higher inflation back to the US.

All that having been said, it is hard to see equity prices falling too far (by

which I mean more than 20%) while profits are strong and the returns on cash

and government bonds so unappealing. The current sell-off can be viewed as a

necessary correction after a very powerful rally. The real test is when the US

raises rates or tries to unwind (rather than simply pausing) QE. The more the

markets wobble, the more that moment will be delayed.

jbay wrote:

Mar 15th 2011 3:58 GMT

Summed up my thoughts exactly. S&P dropped below the 50 MA and might test the

200 day MA but because of inflation I don't think a down trend will continue

beyond the 200 day. Business activity is strong and today's problems are

tomorrow s job stimulus.

Probably around the beginning of April to the end of May would be a good time

to be buying in incrementally. As long as nothing else crazy happens of course.

Adam Onge wrote:

Mar 15th 2011 7:18 GMT

By definition, three sigma events are not supposed to come in battalions. Using

simple Gaussian models to measure "exposure" is "risky".

bampbs wrote:

Mar 15th 2011 9:04 GMT

I'm pleased to see the markets responding negatively to bad news. When they

stop doing that, it's time to edge over toward the exits.