BT: Behind the great sell-off (15 Jun 2006)

Business Times - 15 Jun 2006

Behind the great sell-off

ONE of the biggest business stories during the last month has been the frantic sell-off in regional stock markets as well as emerging markets generally. The Tokyo market is down about 20 per cent from its early April peak; India's Sensex is down close to 30 per cent since hitting a record on May 10; the Jakarta Composite has lost 20 per cent since May 11, Korea's Kospi is down 16 per cent, also since May 11. And here at home, the STI is about 13 per cent off its May 3 high. Markets in Latin America and Eastern Europe have taken a drubbing as well and in the last four weeks, emerging markets as an asset class have lost close to 20 per cent of their value in US dollar terms. By comparison, US and Western European markets are down by single digits over the same period.

While the selldown in markets that had sharp run-ups and were beginning to resemble bubbles - as in India - is healthy, the indiscriminate nature of the sell-off underlines just how strong contagion has become in emerging markets. It is partly a result of the fact that increasingly, it is international, rather than local, investors, that are the biggest market movers. But on this occasion, something more than routine profit-taking is at work; there is a clear trend of a flight to quality. But why?

Part of the answer has to do with the signals emanating from the US Federal Reserve. Having suggested in April that further interest rate hikes might be suspended, Fed chairman Ben Bernanke appears to have made an about-turn, saying on June 5 that near-term evidence of inflation is 'unwelcome'. Around the same time, Fed alternate governor William Poole said the Fed needs to keep an 'upward bias' on interest rates. And then on June 12, Fed governor Sandra Pianalto, said that the inflation picture, if sustained, exceeded her 'comfort level'.

All of which suggests a high probability that the Fed will hike interest rates for the 17th successive time to 5.25 per cent come June 29, which would make this the longest tightening cycle since 1979. This expectation - which is also positive for the US dollar - might help explain part of the emerging market sell-off. It might also explain the flight away from gold and other precious metals, as well as commodities, which, too, have taken a battering in the markets during the past month.

However, it might be argued that the upcoming rate hike was already discounted and cannot be the sole cause of the sell-off. It may be then, that the second-round effects - particularly of a US economic slowdown - have begun to loom large on investors' horizons. While the danger of recession is small, that of slower growth is not - especially if the US housing market, which has helped prop up consumer spending, also starts to slide in the wake of rate hikes. Investors might thus be looking beyond the hikes, to their effect on the real economy. If that is the case, there are two key implications for emerging markets. One is that some of the more upbeat growth projections - including for Asian economies - might have to be revised down. And the other is that the tide of capital that has just departed emerging markets might not be in a hurry to return.

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