Investment flows: Reverse and reverse again

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By:
Peter Koh
Published on:

Hurricane Katrina blamed for extreme changes in cross-border flows.

In the aftermath of Hurricane Katrina, US investors dumped international stocks and reduced their risk exposure in a change of sentiment so violent that it draws comparisons with the LTCM and Russian crises of 1998.

For most of the year investors have shown a healthy appetite for risk. US investors have been particularly keen, increasing their exposure to equities in general and international equities in particular.

In September, however, US investors had a dramatic change of heart. They sold international stocks in large numbers and ran for cover back home. The extreme shift in sentiment, interpreted from cross-border fund flows, has been compared with the LTCM and Russian crises of 1998 and the Y2K hysteria that caused markets to plunge in 1999.

According to State Street Global Markets, which analysed the cross-border fund flows, investor sentiment fell into what it classifies as the most extreme level of risk aversion.

This level of sentiment, which State Street calls a “riot point”, typically signals a broad-based retreat from equities in general in favour of bonds or cash.

Then, in October, investors had another change of heart. Cross-border flows went into reverse as investors herded back into Japanese and emerging-market equities. The degree of flows into those markets most exposed to the global business cycle suggests a degree of risk appetite that State Street says is typical of a “leverage regime”, the most extreme level of risk appetite.

Such an abrupt reversal in flows and sentiment has occurred on only two occasions in the past 10 years. In both cases, it happened during periods of stress in emerging markets – the Asian currency crisis in 1997 and the Brazilian float in January 1999.

Typically, investors’ risk appetite adjusts more gradually. After reaching “riot point” investors usually become neutral, avoiding Asia, or modest, going to developed markets, or only the most liquid emerging markets.

On the two previous occasions in which flows and sentiment swung so violently, significant catalysts, such as the IMF’s approval of a $57 billion bailout package to South Korea, were clearly responsible.

“We typically don’t see such an abrupt move from the most extreme measure of risk aversion to the most significant risk seeking level,” says State Street investment strategist Brian Garvey. “The only thing that might explain it is perhaps that investors just overreacted to fears that growth in the US and the rest of the world would be hurt by the damage caused by hurricane Katrina and that investors are relieved by the fall in oil prices.”