Traders on the world’s financial markets left for home on Friday night counting their losses after a week of extreme turbulence that witnessed the biggest one-day fall in share prices in London and New York for three years.
Fears that rising inflation might prompt central banks to keep raising the cost of borrowing triggered a sell-off which sloshed through all markets — putting the skids under the dollar, sending commodity prices on a rollercoaster ride and prompting cautious investors to seek out the traditional safe haven of gold.
Metals prices slid in further bumpy trading on Friday with copper, nickel and aluminium slipping up to 10%. Oil prices also fell by more than $1 a barrel to around $68 a barrel while London stocks saw the biggest weekly fall for four years.
Stephen Lewis, an economist with Insinger de Beaufort, said the past week had been one of those unusual periods when the price of equities, bonds and raw materials moved in the same direction. When that happens, he added, the markets have normally sensed change in the air — and that change is that the Bank of England, the European Central Bank, the Bank of Japan and the US Federal Reserve are going to make credit more expensive.
”The central banks can be happy that the monetary brakes are still working,” he said. ”The key question now is how rough the ride will be before the markets settle down to cruising speed.”
When the first wave of selling hit stock markets eight days ago, it was easily brushed aside as a mere blip. But Monday saw a plunge in commodities prices, downward pressure on the dollar and a further sell-off in stock markets. When dealers in London sloped off on Wednesday to watch the Champions League final, their screens were awash with red, depicting the FTSE 100’s 170-point fall. By the time Barcelona had lifted the trophy, Wall Street was down more than 200 points and some dealers were wondering if something more serious was happening.
At the centre lies the US — the world’s biggest economy and the fastest-growing country in the developed world for a decade or more. America has been living beyond its means at individual and national levels. Americans have been borrowing to consume, creating record levels of personal debt and a record trade deficit.
Since one country’s trade deficit is another’s trade surplus, by definition there have to be countries where people are living well within their means and where exports exceed imports. Germany is one such country; China is another.
China’s boom is closely linked to America’s role as the world’s consumer of last resort, because factories in East Asia can churn out goods knowing they can be sold on the other side of the Pacific. As a result, China’s economy is growing at a rate of around 10% a year, while industrial production is increasing even more rapidly.
But China is not especially well-endowed with fuel and raw materials to sustain this level of output growth, and has been forced to import oil and metals. It takes time to build new oil refineries or excavate new mines, and as a result the prices of commodities have increased. Copper, a key component in many industrial processes, is six times higher than five years ago while oil prices have tripled since Saddam Hussein was toppled.
Economic theory states that when a country is running a trade deficit as big as that in the US, its currency falls in value so that exports become cheaper and imports become dearer. Consumers buy fewer goods from overseas, turning instead to home-grown goods; the trade deficit narrows as a result.
This has not happened in recent years. The Chinese and other Asian countries do not want to see the Americans lose the spending habit so they have bailed the US out by purchasing its assets. Wall Street looks each month to see whether the trade deficit — running at just under $70-billion a month — is matched by purchases of shares, treasury bonds and other assets. Up until now, it has been.
The strong demand for US assets boosts the value of the dollar, exactly the opposite of what is needed to lower the trade deficit. A stronger dollar means cheaper imports, so incomes go further. It also means that inflationary pressure is weaker and that interest rates can therefore remain low. Low interest rates have encouraged consumers to borrow, driving up house prices in the US. Higher house prices, in turn, have created a feelgood factor, encouraging more borrowing.
A further upward twist comes from oil-rich countries. They cannot spend all their windfall gains at home, so the petro-dollars from Saudi Arabia or Russia find their way into the world’s financial markets. This keeps prices buoyant.
A case can be made for the strength of all the different financial markets. Shares? In London and New York they are still below the peaks reached in the dotcom boom. Corporate profitability is high and the world economy is enjoying its best spell of prolonged growth since the early 1970s. Commodities? Add some geo-political tension from the Middle East to three decades of under-investment in new capacity and higher prices are inevitable. China will carry on booming until the 2008 Olympics at least, keeping demand for energy and industrial metals high. The dollar? It’s the world’s reserve currency; fast-growing America is a better place to invest than slow-growing Europe; and it is not in the interests of the Asian central banks to dump their dollar-denominated assets, since they would only be driving the price down against themselves.
Pessimists say that this virtuous circle could quickly turn into a vicious circle. Should overseas investors take fright at the scale of the US trade deficit and diversify their portfolios out of dollar assets, the US currency could fall quickly and bring share prices down with it. A weaker dollar and falling asset prices would hit consumer spending in the US, with worldwide effects. Slower growth would then take the froth off commodity markets. Given that possible scenario, it is perhaps no surprise that there has been plenty of action in another market: that for gold. The traditional safe haven in times of trouble is much in demand.
Key warning signs
Icelandic krona
The run on Iceland’s currency in March was an early warning sign. Iceland had benefited from the carry trade where investors borrow money in currencies with low interest rates to buy the krona in Iceland where interest rates were raised this week to 12,5%. But these trades are the first to be unwound when investors are worried about global markets.
Chavez and Morales
Protectionism can threaten the world’s trading system and unnerve investors, and Venezuela and Bolivia have become more protectionist. Earlier this month Evo Morales, Bolivia’s President, took a big step towards nationalising his country’s gas and oil industries. Venezuela’s President Hugo Chávez angered the US by stopping oil supplies to them.
Russia
Relations between the US and Russia have become increasingly strained as the US accused President Vladimir Putin of using gas and oil supplies to blackmail Europe. Earlier this year Russia briefly turned off supplies to Ukraine. Putin wants state-owned energy companies like Gazprom and Rosneft to become global giants
Iran-US standoff
Tehran’s announcement this year that it was enriching uranium that can be used in nuclear weapons drove up crude oil prices. The United Nations called for Iran to suspend enrichment but this has been ignored by Iran which instead threatened to embargo oil supplies to the West. With the second largest reserves in the world, this would have a severe impact globally.
Turkish lira
Turkey, a vulnerable emerging market, has been a beneficiary of the global carry trade but was badly affected by the fall in world markets. The selling pressure of this week saw the Turkish lira fall by 6,1%. Inflation jumped to 8,8% in April leading to a bond market sell-off. Turkey’s current account deficit is also forecasted to hit 6,1% of GDP next year.
Gold
Investors usually buy gold when they are worried about other markets and geopolitical instability. The gold market recently hit a 26-year high of around $720 per troy ounce. The surge in demand for gold could signal trouble ahead in the global economy and a fall for the US currency. – Guardian Unlimited Â