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Against the tide: Stock market sell off – This time it is different

The recent sell-off in global stock markets will not be a repeat of last May – a short correction leading to new highs. There is now more to worry about in the global economy and the liquidity cycle is at a turning point.

There are dangers, now real and present, that constrain the credit cycle and the global economy.They were not there a year ago. In May 2006 the fear was of renascent inflation. Had this occurred, liquidity would have shrunk. Higher inflation would have pushed up bond yields. The derivatives markets would have done the rest.

But inflation did not happen. Oil prices fell. Global manufacturing went into an inventory correction. This caused goods prices to be weak, especially in the US. Markets hit new highs.

There is more to worry about now. A plus in the yen’s fortunes is a minus for global liquidity. The yen supplies 15% to 20% of all the stuff sloshing around inside the liquidity pyramid. As a source of funding the yen is big for New Zealand and Australian dollars and a host of other high-risk assets such as Indian and Chinese equities, emerging market debt and mortgage lending in far-flung places such as Seoul, Romania, Austria and Spain.

In Japan, households hold a lot of foreign assets they don’t understand, investment institutions have some scary overseas exposure and the banks have been growing their foreign loan books massively and are at the centre of the broadly defined yen carry trade.

A second worry factor is the global profit cycle. Falling productivity growth and rising unit labour costs, running at about 3% year on year, are squeezing margins. If the current global inventory correction also causes job losses and even weaker capital expenditure, that would be bad news for the economy.

If the profit cycle weakens, excess corporate cash will dry up. It will be sorely missed in markets, particularly in the Anglo-Saxon ones. Corporations are responsible for global excess savings. This is the only non-monetary phenomenon underpinning the liquidity cycle. It represents the gap between profits (which are at peak shares of national income almost everywhere) and investment in productive assets (which is weak). The excess cash has been ploughed into financial markets – bonds, M&A, share buybacks and so on.

This is probably irrational. If the collective captains of industry don’t think their business is a good investment, why would their financial liabilities and equity be a better one? Being irrational, it is an example of excess. Only a reversal of the liquidity cycle or the fortunes of the real economy can expiate it.

Unstable foundations

US Sub-prime mortgage delinquency rate

Source: Bloomberg

A third worry is inflation. Despite falling oil prices and weak manufactured goods prices, inflation is not that well behaved. This is probably because cost pressures are becoming price pressures as the productivity cycle weakens. The US shows the most signs of this. But Europe is not immune. There is a whiff of stagflation in the air. The recent sell-off was in part prompted by the Chinese equity market, which is the financial market equivalent of what dog racing is to gambling – a third-class sport attended by fourth-class punters. That the Chinese authorities burst this bubble is no wonder. The Chinese are tightening liquidity because they have an inflation problem that is intensifying. This will hit growth and deflate bubbles related to the inflated China story.

The US sub-prime mortgage market is emitting shrieks of agony. Default rates are up more than 13%. Underlying derivatives have tanked. The fear is that the damage to banks and other intermediaries will cause the credit cycle to reverse. Then US housing would tank even more and drag the whole economy down.

This has not happened so far because the sub-prime market is small at 10% of total US outstanding mortgages. And the majority of sub-prime loans are made to people who were bust to begin with and are now a little more so. Also, the derivatives market is doing its job of absorbing the sub-prime shock. However, the risk of a spillover has increased. It is not yet clear that the US housing market has troughed. Forward-looking indicators such as housing starts appear to be in free fall.

Meanwhile, global liquidity is tightening. The unwinding of the yen carry trade might mean less capital will be pumped into mortgage bonds. This would lead to a general rise in long-term interest rates. Investor risk appetite has diminished, as falling equity markets testify. There may be more pain to come.

David Roche is president of Independent Strategy Ltd, a London-based research firm.

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