The hurricane that swept across share and commodity markets last month wasn't triggered by investor fears over inflation, economic growth or corporate earnings the reasons generally given in the financial media but by a blow to global speculators delivered in Japan.
- If coming inflation were the problem, it wouldn't make sense to sell gold (one of the hardest-hit assets) or to stay in bonds (one of the least-affected).
- If economic growth were the problem, central banks wouldn't be united in an interest-rate-raising strategy.
- If the corporate earnings outlook were the problem, analysts' profit forecasts would be starting to signal it.
No, what we have been seeing is a liquidity squeeze threatening the huge amount of credit-based speculation that has been driving up the value of most investment assets for several years.
The main international source that of credit has been Japan, which has been "printing" money on an unprecedented scale as a successful strategy of (a) underpinning a dodgy banking system, (b) preventing its economy from slipping into recession, and (c) stimulating a sustainable pick-up in domestic demand and consequent economic growth.
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The Japanese central bank (not the Fed) has been the principal source of the flood of cheap credit that has boosted asset values in recent years. Its monetary base has actually grown larger than the Fed's. Hedge funds and other short-term players have been able to borrow enormous amounts in Tokyo at near-zero interest rates to finance their worldwide speculations.
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To start to address unhealthy imbalances in the nation's financial system such as unlimited credit, excessive national debt, and inadequate provision for the pension and health costs of an aging population, the Bank of Japan has slashed monetary growth to ready itself for interest-rate hikes.
When it suddenly sucked the equivalent of some $200bn out of the global financial system, international speculators panicked. They realized that this would deflate the bubble in high-risk assets such as junk bonds, emerging market securities, small-cap stocks and commodities. So they rushed to sell.
It was "a financial Pearl Harbor for many hedge funds," says the well-known Canadian strategist Donald Coxe.
The shock sent such tremors through the global financial system that at one point the International Monetary Fund apparently asked the Bank of Japan to reverse its tight-money policy. Which it did, temporarily, calming the markets by saying that it wanted the yen interbank rate to remain at "effectively zero per cent."
But not for long. The bank has signalled that next month it wants interest rates in Japan to start rising. Initially by a quarter of 1%.
So it looks like further squalls ahead for global investment markets that have been bloated by speculation financed by ultra-cheap credit.
"We are in a situation where all asset classes are under pressure because of a reduction in liquidity," says mega-speculator George Soros.
As an international investor, what should you do now?
- Don't panic. It's probably too late to turn devalued assets into cash.
- Another reason for not panicking is that global fundamentals still look good. The biggest risk is a collapse in the US residential property market that would clobber economic growth. But if that seemed to be developing, the Fed would immediately reverse course and start cutting interest rates.
After-shocks of the Japanese financial earthquake
- The markets are likely to be relatively quiet for the next few months as disenchanted investors maintain some downward pressure on prices, while cash-rich buyers linger on the sidelines awaiting convincing evidence of the start of a new uptrend.
- However, it's possible that the smartest money will begin moving back into higher-risk assets ahead of when seasonal and other factors suggest the uptrend should otherwise commence (variously forecast as between late September and the first quarter of next year).
- So charts of the major asset classes need to be watched carefully through the (northern) summer for the first signs of a sustained renewed uptrend for you to buy into.
By Martin Spring in On Target, a private newsletter on global strategy
