Recent market gyrations have captured the attention of investors who may question whether the end is nigh for the four-year bull-run on global equity markets. Even their trusted investment advisors may not have all the answers, so it is often helpful to examine where the “smart money” is heading.
Institutional investors have largely stuck with equities but have been shifting out of riskier assets and into more established markets, according to a report from State Street Global Advisors.
“This move has been quite dramatic,” the report says. “Just one month ago, 10-day flows into Emerging Asia were in the 65th percentile. They have now slumped to the 5th percentile.”
In other words, over the 10-year history of SSgA’s cross-border equity flow indicator, flows into Asia were higher for 95% of all previous two-week periods.
Part of this may be accounted for as profit taking, as the MSCI Emerging Asia Index has gained 234% since the beginning of 2003, while the overall MSCI World Index is up “only” 98%.
“Given this strong outperformance, a rotation away from emerging markets was inevitable at some point,” the report says. State Street calculates that there is a 55% chance that the current risk-averse mentality will persist, but that there is an 18% chance that institutional investors will shift into an even more risk-averse regime, characterized by “indiscriminate equity selling.”
What is most unlikely is a return to the risk-seeking that has characterized the market for the past four years.
“Those hoping for an end to the crisis afflicting sectors of the credit market are whistling in the dark,” the report says. “If things are bad for plain vanilla mutual funds, imagine the fate of leveraged players, or the holders of equity stubs of collateralized debt obligations backed by asset backed securities.”
To wit, SSgA says it was not surprising that BNP Paribas announced last week that it could not properly value some of its asset-backed securities. That announcement sent global equity markets into a tailspin, proving that lending money to poor credit risks in the U.S. could have a global impact. Further suspensions of valuation could follow.
The world’s central banks dumped over $238 billion in extra liquidity into the market, which seems to have eased tensions, but many are looking for even more help from the U.S. Federal Reserve.
“In the space of a few hours on Thursday, the chances of a Fed rate cut in September increased from 20% to 60% in the interest rate futures markets, and a quarter-point cut in the next two months is now fully priced in,” the SSgA report says.
Lower interest rates in the U.S. could help to stave off future mortgage defaults in the subprime market and help to avert a catastrophe when a larger cohort of step-up mortgages raises subprime rates in 2008.
But not every central banker is on board with such a move. Bank of England governor Mervyn King has told reporters, “Interest rates are not policy instruments for protecting unwise lenders for the consequences of their decisions.”
In the near term, investors may want to increase their allocation in tranquillizers and nausea medication.
“The one sure thing is more volatility,” the SSgA report warns. “The close of September is the accounting year-end for many U.S. mutual funds and often sees a squaring of positions, which means liquidity can suffer. October is a month synonymous with market travails.”
Filed by Steven Lamb, Advisor.ca steven.lamb@advisor.rogers.com.