Markets took a bit of a knock yesterday.
The FTSE 100 closed down 2.6% at 4,326. Both the French and German stock markets shed more than 3% each, and the Dow Jones lost nearly 200 points.
Now we haven’t seen a 100-point drop in the FTSE 100 for – oh, at least a month or more now – so what was behind this attack of the vapours?
Very little, it seems at first glance. Which suggests that investors may just be experiencing a little reality check…
What’s worrying investors right now?
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There wasn’t much by way of concrete data to cause the big fall in markets yesterday. That’s probably one reason for the scale of the slide. Without anything to trade off, investors can let their imaginations run wild. And at the moment, the façade of optimism is papering over an awful lot of genuine reasons to be fearful.
The question at the back of everyone’s minds – as we alluded to in yesterday’s Money Morning (Emerging markets will be the winners from this crisis) – is this: “What happens when the money’s all gone?”
This is particularly worrying investors right now because the recent G8 meeting was all about central banks and governments starting to consider how they should reverse quantitative easing and all the other little interventions that have apparently been keeping financial apocalypse at bay.
This is a problem. Because, as David Rosenberg of Canadian asset manager Gluskin Sheff put it in his morning briefing, “investors have no clue how the global economy or the financial markets can operate on their own two feet.” So at the first hint of governments withdrawing, they’ve pulled their money out of the market. “A future without a government subsidy doesn’t look so promising for all these once-successful beta trades.” (In case you’re wondering by the way, beta just refers to the portion of an investment return that can be attributed to the wider market rising or falling).
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And as investors fled equities and commodities, they jumped back into “safe havens” such as the dollar. In fact, as Ambrose Evans-Pritchard puts it in The Telegraph, among the Bric nations (Brazil, Russia, India, China) there currently “appears to be a co-ordinated attempt to talk up the dollar.” This will be reassuring for the US government – as long as investors are scared of recession, there’s a market for its debt. And those nations that already hold its debt aren’t yet in a position where they can just allow the dollar to slide.
So investors shouldn’t be worried about governments failing to prop up the markets just yet. The recent surge in government bond yields, and headlines in the papers about massive fiscal deficits may have startled the authorities into talking up exit plans and talking down the markets. But the reality I suspect is that central banks have no intention of calling a day on money printing until they are positive that asset prices have bottomed out.
That means inflation lies somewhere in the future. But we’ve still got plenty of deflationary forces to deal with and more financial shocks to come.
Why the next big market shock could come from Europe
Europe looks increasingly like being the location of the next big blow-up. Our new addition to the MoneyWeek team, ex-City trader Riccardo Marzi, reckons that Latvia’s likely devaluation could have some nasty consequences for the eurozone. (Riccardo also has some great trading ideas, which you can learn about here.)
But Latvia’s far from the only problem for Europe. There’s still the little matter of collapsing post-housing bubble economies such as Ireland and Spain. Irish consumer prices fell at an annual rate of 4.7% in May – now that’s deflation for you. Meanwhile, Moody’s yesterday downgraded 25 Spanish banks amid continued rising bad loans. The credit ratings agency warned that “unless some supportive measures are taken by third parties – by owners, or more likely by the government – some banks’ capital cushions will soon be affected by asset impairments.”
The trouble is that Europe’s banking system is even further behind in terms of recapitalising and coming clean about losses than the US or the UK (neither of which have finished with write downs yet, by any manner of means). That means that currently there is arguably more room for shocks in the eurozone than elsewhere.
The best way to bet against the euro
Unsurprisingly, the euro sold off against the dollar, although it rebounded this morning. There’s still plenty of potential for the single currency to get a lot weaker – it hasn’t really had its turn at being the butt of currency traders’ shorting yet – but anyone thinking of playing it might be better to sell it versus the Japanese yen, rather than the dollar, particularly as the yen is benefiting from increasingly optimistic noises from the Bank of Japan.
In our current issue we take a look at how to trade the currency markets, and some of the best-looking plays at the moment (you can read the piece here: Foreign exchange: where to place your bets in the world’s biggest casino – if you’re not already a subscriber, subscribe to MoneyWeek magazine).
Our recommended article for today
Is the Federal Reserve fuelling another crisis?
The Federal Reserve is treading a very fine line with its quantitative easing programme. With the dollar so weak, it runs the risk of igniting another financial crisis.