Global financial markets have witnessed a series of convulsions in recent weeks, whether in stocks, bonds or currencies.
Many are describing it as a healthy correction, because some markets had risen too far, too fast - in other words, the bull run is intact, but taking a breather.
Certainly, stock market investors do not appear to be overly concerned. Many have been picking up bargains during the selloff, making the downdraft seem more symbolic than real.
The U.S. S&P500 is still up on the year (about four per cent), while Toronto's TSX is up around seven per cent (at the time of this writing). Emerging market stocks are off their peaks for the most part, China being the main exception, but so far the correction has been smaller than that of June 2006.
But look a little deeper and some cracks are beginning to appear in investor confidence. At the root of this is the recession in the U.S. housing sector. What began as a temporary adjustment has become an all-out downshift in the willingness to purchase a home.
Lenders with large home-mortgage portfolios are being penalized heavily in financial markets. While it is still possible for this macroeconomic disturbance to end there, there are signs that this negative sentiment is beginning to influence other consumer spending decisions in the U.S.
The U.S. economy has clearly slowed. The implications for the world remain to be seen, but the uncertainty is definitely affecting financial markets. A deleveraging process has begun - banks are making less liquidity available, whether because of rising short-term interest rates in certain countries, or because their mortgage portfolios look fragile, or because they have grown more cautious. Margin investors have become more cautious, too, reducing their leverage willingly.
The results may be seen in all the places where leveraged plays have become common in the last couple of years. U.S. corporate bond spreads have widened, particularly in sub-investment-grade deals. A number of high-profile debt deals have been shelved for the time being. Emerging market bond spreads have widened by about 100 basis points since early June, half of that in just the past two weeks.
This move, in fact, has been much larger than the one seen a year ago, although spreads still remain low by historical standards. Meanwhile, 10-year U.S. Treasury bond yields have dropped by about 50 basis points as bond investors seek shelter.
The effects have also been apparent in currency markets. The most important source of liquidity for leveraged investors has been the Japanese yen (the yen carry trade).
For example, the yen fell by eight per cent through March-May as investors borrowed yen at low interest rates, sold the yen and bought rising assets, like the Canadian dollar. During July, the yen retraced most of that move, rising by six per cent. Correspondingly, such currencies as the Canadian dollar and the Australian dollar have been retreating from their speculative peaks.
The bottom line? There is no bottom line as yet, for we are watching a market in transition. The characteristics are those of a shift to slower growth and the associated erosion of investor confidence. But the process is far from complete, and is unlikely to proceed in a straight line.
(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
