Tuesday, 28 October 2008

No End in Site: Global Markets Exhibit Continued Weakness

The extreme turbulence that has characterized markets in recent weeks shows no signs of subsiding. Yesterday global stock prices fluctuated between huge losses and huge gains until finally settling on losses in most western exchanges by the close of trading (including massive losses in Toronto's TSX, -8%). China's main exchange, in contrast, experienced a gain of nearly 15% by the end of trading. Extreme volatility has persisted today (12:30 pm).
In addition to violent movements in almost all classes of assets, currency has failed to provide any haven for the cautious. Currency 'imbalances' have left the global economic outlook even more precarious. The financial news today is awash with articles commenting on the destabilizing nature of the current valuation of currencies. The Yen (Japan's currency) has been, and is still, rapidly appreciating in value against other currencies while the dollar has continued its somewhat slower rise as well. We are seeing a catastrophic depreciation of developing nation currencies.


How do we interpret this?

Let's begin with asset price volatility. Investors do not like extreme price fluctuations. For markets to function investors need to be able, or feel able, to reasonably assess the riskiness of their prospective investments. This means that when markets behave moderately (exhibiting slow, steady, secular changes) people feel as though they have a better grasp of the future and are therefore more willing to put their money where their expectations are--this could mean betting up or down. When prices are subject to erratic shifts, the outlook for the future is more difficult to determine. Thus investors feel less comfortable about their ability to make good decisions in the market. This leads many to sit out. This phenomenon is frequently referred to as risk aversion.
Even with the prospect of huge gains in some assets and some exchanges (yesterday only China), extreme volatility is yet another factor compounding the deterioration of the global financial world. The period of relative tranquility experienced in the five years leading up to the beginning of the crisis of global capitalism (2002-2007) was heralded as a sign that a new era of predictability had arrived. It was called the "Great Moderation." It seems now that those days are gone. In fact, present turbulence in the markets and the retrospective view of huge asset bubbles, calls into question the very logic of the moderation. The fate of the global market remains precarious. This is new to investors accustomed to predictability but those of us who work for a living have become increasingly accustomed to the precarious nature of employment and compensation in the past decade.

Currency fluctuations are directly linked to the current crisis, however, the connection is far from intuitive. The rapid appreciation of the Yen is a result of the market actors' belief that Japan's economic strength provides a haven for investors. This has proved a self-fulfilling prophecy as increased demand for the Yen has forced the currency higher. The dollar is benefiting not from a perception that the U.S. economy is healthy (no fool would believe that), but because the dollar is still the global currency. Possibly more importantly, investment funds that are pulling out of the markets (hedge funds especially) are liquidating their holdings in global markets and money is returning home to the United States. This is another reason we are seeing devastating depreciation of developing market currencies, though it is probably the tip of the iceberg. Hungary, Pakistan, Iceland, and Ukraine are all teetering on the edge of all out financial collapse. South Korea, Brazil Philippines and Indonesia are moving quickly towards crises induced (at least partially) by rapid falls in their currencies.
To put this in perspective, an appreciation in the dollar all but eliminates the chances of an early rise of U.S. exports to save the economy from a recession and will, in all likelihood, help to maintain or worsen the trade imbalances that contributed to the crisis in the beginning. For developing nations, currency devaluation will exacerbate the food crisis by counteracting the recent falls (from all-time highs) of food prices. On a related note, the U.S. and Japan can feel free to keep cutting interest rates as the appreciation in their currencies has finally laid low any remaining fears about inflation--although these fears have probably been of the irrational variety since August 2008.

The IMF could soon deplete its reserves to an extent that would leave it essentially impotent in the face of the crisis just as it is hitting nations hardest. It is the IMF's mandate to prevent nations from collapsing. Now as many national governments balance on the brink of catastrophe, the IMF is in a position in which it will very likely have to pick and choose who it will lend to.

Surplus-rich China, Russia and the Gulf States may be asked to step up to the plate to prevent the failure of national governments... but didn't we (the West) want them to start generating growth through increasing internal demand? It seems unlikely that they can do both.

As we all watch the international economy breakdown, we all become acutely aware of the fragility and complexity of the capitalist mode of production. It now seems justifiable to step back and marvel at the fact that it was ever able to function smoothly.

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