Global Insight Perspective

Significance

Most markets worldwide had been swollen by optimism over recent months—many chalking up all-time highs—and though a correction was likely before long, the falls have been exceptionally sharp and in many cases the past year's gains have been erased.

Implications

It is too early to talk about a true crash; there are indeed some tentative signs of stabilisation today despite the continuing sell-offs in many markets. Emerging markets have nonetheless been hit hard, with those that led recent gains suffering the sharpest corrections.

Outlook

The U.S. durables data indicate that the economy's outlook is not as reassuring as Federal Reserve chairman Ben Bernanke has been insisting, but more evidence is required before his predecessor's gloomy prognosis is corroborated. There remains some optimism that the U.S. market can lead a quick recovery later today, but investors will remain jittery and more risk adverse.

Investors Spooked

A combination of factors hit investor sentiment in most markets worldwide yesterday, and exceptionally sharp falls were registered. The most significant factor was the release of U.S. durable goods order data for January. The 7.8% plunge contrasted with the largely benign data seen from that economy in recent months and raised concerns that the growth slowdown this year could be sharper than previously thought. Iconic former Federal Reserve chairman Alan Greenspan added to the jitters with a comment that the United States could fall into recession by the end of this year. His tone was in contrast with the comparatively upbeat current Fed chairman, Ben Bernanke. Full details of the durable goods data release follow below.

That data came on the same day that China's Shanghai market endured a dramatic 9% fall, quickly followed by other major Asian markets. Chinese stock markets are notoriously volatile, dominated by short-term speculative trade, and shallow, with indices heavily populated with former state-owned entities. Foreign participation is limited and regulated under extensive capital controls. Trade in shares has surged as individual investors have ploughed savings into shares for quick returns, with signs of "irrational exuberance" emerging. Liquidity in the Chinese financial system remains high, fuelled by surging foreign capital inflows, the strength of which has negated recent attempts by authorities to tighten monetary policy. Surveillance systems and information distribution systems remain immature, exacerbating "casino"-like trades. On Monday (26 February), the Shanghai composite index broke through the 3,000-point ceiling, magnifying the subsequent crash as a sell-off ensued the following day. Sentiment was rattled by rumours that the government was preparing to impose new regulations to restrict share trades amid fears that a bubble may be building. Sharp reversals in Chinese markets are not new, while the potential for external ramifications is contained by the limited level of foreign participation. The proliferation of volatility to other regional markets is, however, a new phenomenon, reflecting the increasing integration of the region’s economies anchored on the mainland’s manufacturing platforms and developing consumer markets. The Hong Kong Hang Seng index fell 1.76%, with the Japanese Nikkei losing half a point in a knock-on effect and fuelling the global chain reaction.

The combination of the poor U.S. data and the Shanghai plunge amounted to a "perfect storm" of sorts for global markets, and spooked investors were soon highlighting a raft of other ongoing concerns such as the U.S. housing market and the situation in Afghanistan (where a suicide bomber struck the base U.S. Vice-President Dick Cheney was visiting), Iran and Iraq. The impact of the Shanghai fall was unusually large in the U.S. market in New York, suggesting that its movements are now being watched much more closely than in the past. The Dow Jones Industrial Average (DJIA) was down 546 points at one point yesterday afternoon, before closing down 416.02, or 3.29%. This was that market's worst day since March 2003, and in points terms was the sharpest slide since the day markets reopened after the 11 September 2001 terrorist attacks on the country. The Standard & Poor's 500-stock index closed down 3.47%, while the technology-dominated NASDAQ fell an even heavier 3.86%. As usual, the European markets echoed U.S. sentiment closely, with the FTSE Eurofirst 300 losing 2.9% yesterday—its largest fall in four years. In early trading today it shed another 1.3%, the two-day fall erasing the year's gains. The United Kingdom's FTSE-100 shed 2.3% yesterday and a further 2% this morning. The market optimism of the last few months has certainly taken a heavy hit.

The falls came at a time when most stock markets have been riding at or near record highs, and those worst hit tended to be the same that have risen the most of late. These are typically in the major emerging markets that have outperformed the mature markets consistently over the last two to three years. High levels of global liquidity are still present, despite higher funding costs due to rising interest rates. Looking at those worst hit by the sell-off, they are largely Asian companies that export to the United States and may face a weaker market than expected. The Asian Development Bank's managing director-general, Rajat M. Nag, said in an interview today that the economic fundamentals of most Asian economies are strong, but he acknowledged that the U.S. market will be key and that this does represent a particular vulnerability for China.

A Closer Look at the Durable Goods Data

The U.S. Commerce Department's data yesterday showed durable goods orders plunging US$17.1 billion (or 7.8%) in January, with civilian aircraft orders crashing by US$11.7 billion to account for 66% of the headline plunge. Sectors enjoying good months in January were few and far between. Defence orders fell further (down 6.2%) after a bad December, automotive orders fell (down 5.1%), hi-tech orders plunged (down 7.8%), and machinery orders were badly hit (down 9.3%). One of the few sectors to sport a gain was electrical equipment, where orders rose 7.9%. The general pattern of weakness was reflected in a 6.0% drop in new orders for non-defence capital goods excluding aircraft. The weakness in core orders is an unfavourable omen for first-quarter 2007 investment—the 2.7% drop in January shipments of these goods, unless revised, will feed into the Commerce Department's formula for calculating equipment investment.

Neither was the durable goods report inspiring in the backlogs and orders series. Durables backlogs rose a paltry 0.1% in January, and although capital goods backlogs rose for a 27th consecutive month, they did so by only 0.9%, almost two-thirds lower than the expansion in December. Durables inventories rose a soft 0.3% in January, but December's inventory build was raised by a billion dollars and is now reported as 0.7%; manufacturing inventory building is slowing erratically, but should be a drag on first-quarter growth. The plus side of the December inventory build is that it will net a small positive influence on fourth-quarter GDP estimates (due out on 28 February), compared with prior information; this small advantage raises the estimate of fourth-quarter growth to 2.2%, though this will still be a large drop from the advance estimate of 3.5% growth.

The first quarter of 2007 has therefore begun with a weak month, much like 2006 ended. The sharp movements in aircraft orders made it look worse than it was, but it still was not very hopeful, even after removing the distortion. The double whammy of weak January equipment shipments and weak January orders does not augur well for the quarter as a whole. The investment sector is not likely to be much of a plus to offset the ongoing drag from housing and the overall slowdown of inventory building (excluding the motor-vehicle sector, which cuts inventories rapidly in late 2006). One of the few consolations is that the back-to-back drops in defence orders make it a high probability candidate for a February rebound, along with the civil aviation sector.

Outlook and Implications

Despite the dramatic newspaper headlines it is too early to talk about a global markets crash—behaviour to date suggests we have largely witnessed a correction as investors take their profits. A "crash" conventionally requires a 20% fall over a short period—although the day falls are nevertheless "severe" in the 2-5% range. Overall, the DJIA is still only down 4.4% from last week's all-time high. The Shanghai market recovered 4% of its value today, although the sell-off continued elsewhere in Asia and Europe. The hope is that the markets are essentially going to a more realistic level in accordance with geo-economic and geopolitical realities. "Risk aversion" among major investors is rising, and this has affected not only stocks, but also the speculative emerging-market bonds. Today's financial investors and hedge funds have truly broad exposures all around the world, including China—directly or indirectly—so the major global investment funds will be affected by the Chinese sell-off even if it has been sparked by "domestic reasons".

One factor to watch closely is the trajectory of oil prices—renewed price rises have always capped and taken the wind out of stock-market rises. Now at a 2007 high with clear upward-spike potential if the Iraq/Iran situations deteriorate, this factor could have a growing impact.

Investors worldwide will be watching the U.S. Federal Reserve even more intently than usual in coming weeks. Could weaker durable goods data persuade the Federal Open Market Committee (FOMC) to cut rates and thereby weaken the U.S. dollar even more? This would of course complicate matters further for those exporting to the United States, although yesterday the dollar gained ground against many currencies as investors took shelter on safer ground.

www.globalinsight.com