Popularising the pullback

From a contrarian perspective, particularly aggravating when one is hoping for even more downside, it serves no purpose to have the popular press suddenly find all sorts of ready reasons for and easy answers to the market weakness of the past week. Still, so long as they do it in a complacent "it was only to be expected" manner, rather than a "there's blood in the street" manner, there is still more downside room from a sentiment indicator standpoint.

The Sydney Morning Herald's political commentator, notes sagely, "It's been too good for too long".

IT'S only when the tide goes out that you can see who's been swimming naked, remarked the billionaire investor Warren Buffett. The world has been swimming in super-cheap liquidity for the past five years.

The worst deals, the lousiest companies and the least credit-worthy countries have had no trouble raising cheap finance. And countries which spend far beyond their means - Australia and the US each consume 106 per cent of their income every year, borrowing ever larger sums to close the gap - have had plenty of investors keen to finance their overconsumption.

But central banks around the world have decided that the days of super-easy money are over. They have started to take money out of circulation, pushing interest rates up.

The big price falls on Wall Street in the past week, quickly mimicked in markets everywhere else, are a clear signal that a sharper appreciation of risk has returned.

The tide has started to turn. Who will be found to be naked? The sudden new fear is most visible in the US. It finds its expression in an acute concentration on the intentions of the man who sets the price of money, the new chairman of the US Federal Reserve, Dr Ben Bernanke, who replaced the long-serving Alan Greenspan in February.

"The market is being weaned off the delusion that, under Alan Greenspan, everything's going to work out fine," said the publisher of Grant's Interest Rate Observer, Jim Grant. "By recklessly admitting that the future is not an open book, Ben Bernanke has sown anxiety where before there was reassurance."

When Wall Street's frenzied technology mania collapsed in March 2000 and swiftly pulled the economy into recession, Greenspan cut official US interest rates from 6.5 per cent to 1 per cent, their lowest in 40 years.

These super-low rates, so low that after adjusting for inflation they were actually negative, helped stimulate a strong recovery in the US economy. That done, the Federal Reserve has gradually brought interest rates back to a more normal level.

"Everything in the market has one ticker symbol now," he said, referring to the trading abbreviations used for stocks, "and it's FED. So leveraged is this economy that another interest rate increase of 25 basis points [0.25 of a percentage point] is a big deal."

The US may be the most visible, but the biggest source of change is Japan, where interest rates have long been set at zero.

The world's second-biggest economy - yes, still more than twice the size of China's - fell into a long stagnation in 1990. Only now, 16 years later, has it emerged to grow at a reasonable pace.

So Japan's central bank has made it clear that, as the economy returns to normal, so will its pricing of money. The vice-chairman of Goldman Sachs for Asia, Dr Ken Courtis, explained: "For the last four years the Bank of Japan has been injecting 35 trillion yen [$420 billion] into the monetary system per day - that's seven times more than the system actually required. Japan has been an extraordinary fountain of liquidity for the world, the biggest source of global liquidity."

Much of the excess was borrowed, at near-zero rates, by investors elsewhere who used the cheap yen to finance investments and speculative bets all around the world on a vast scale. This is known as the yen "carry trade". But this game is coming to an end. The Bank of Japan is now supplying about 14 trillion yen a day to the market, and is signalling that, as Japan's recovery progresses, it will continue removing its excess monetary stimulus.

As this great ebb tide of global liquidity begins to gather pace, it is time to move away from risk. That's exactly what is driving Wall Street's sharp sell-off; investors are selling shares to take their cash and retreat into safety.

As the sell-off continues, can we predict who will be exposed? The first to be exposed as being naked are speculators, some of whom, after pushing commodities like copper to stratospheric heights, have already been burned by the reversal in recent days.

"To see who'll be exposed, you have to ask what are the excesses of this cycle," said Grant. "In the US, it's been no-money-down, non-amortising mortgages to finance real estate. So, as the real estate sector is sold off, a lot of my fellow countrymen will be as naked as blue jays."

And the business pages' apologist, Stephen Bartholomeusz, writes, "US markets find excuse to retreat", as if they had simply lost a hanky and then found it again and so would be on their merry way without a care in the world for other fingers of instability:

THE wobbles in global markets triggered by fears of further interest rate rises in the US in response to higher than expected inflation may test the thesis that hedge funds are driving a speculative bubble in commodity prices.

The simultaneous sell-offs in commodities and equities and the general volatility may not, of course, presage much more than a glitch in the three-year bull market that has coincided with the explosive impact of China on global economic activity and demand for resources.

Given that our market has risen about 34 per cent in a year and almost 60 per cent in the past two years - that latter figure being almost identical to the average price increase achieved by Australian non-rural commodity exporters over the period - an eventual correction was to have been expected.

But this week's sell-off was more broadly based and centred on the US. If the Fed keeps raising rates, the US economy will slow, its housing market will be affected and US households, with record levels of leverage, will scale back consumption. If that happens, the world economy, which has recorded strong growth despite high oil prices, will also falter.

That would then flow back into demand for Chinese manufactures and then into demand for commodities, lowering prices. That's one scenario.

Economies aren't in such bad shape and, given the rate at which the Chinese economy has grown in recent years, even a slowdown in its demand for resources should have only a marginal effect on the supply-demand balance for commodities - it will be slowing from a base that is much larger than it was before China took its great leap forward.

Even our equity market, which could be regarded as risky, given its rise in the past few years, isn't wildly overvalued. Its overall price/earnings multiple hasn't changed materially in three years - underlying earnings have grown at similar rates to the market - and even resource company share prices have tracked their earnings growth until recently.

The US market hasn't performed as well as ours, which suggests it isn't wildly out of whack with its fundamentals at a time when the US economy has been travelling quite well.

Given the leverage some hedge funds employ, there is concern that any uncertainty about either China's growth and/or the US economic outlook could trigger a rout as the funds rush to escape their commodity exposures.

It isn't clear the commodity boom contains another asset bubble, given that the prices of commodities sold under contract, like iron ore, have also rocketed. With China absorbing a third of the world's output of iron ore and coal (and more than 20 per cent of its copper, zinc and aluminium), it is possible a structural change has occurred in the global economy and commodity markets.

That doesn't mean markets have not got ahead of themselves.

It is conceivable, particularly if the hedge funds are highly leveraged, that the prospect of further rises in US rates may have sparked a sell-off in commodities that had been inflated by the euphoria regarding China and the accompanying speculative activity.

A more prosaic view would be to say that anything that runs so hard and fast for so long - such as commodity prices or, indeed, our equity market, will inevitably face some correction as the marginal sentiment turns from greed to nervousness.