Economic sentiment undermined by double whammy

Economic sentiment undermined by double whammy
By Tony Tassell
Copyright The Financial Times Limited 2006
Published: September 23 2006 03:00 | Last updated: September 23 2006 03:00


Investor sentiment was jolted this week by a revival of two key market risks - a hard landing for the US economy and emerging market instability triggered by political crises.

Just as risk appetite appeared to have fully bounced back from the turmoil that unfolded in May, investors' nerves were unsettled by fresh evidence of a US economic slowdown and political troubles from Thailand to Hungary to Brazil.

The emergence of big losses suffered by US hedge fund Amaranth also underlined the risk of large, leveraged investors caught out by adverse market moves.

US Treasuries had their best week in 17 months, benefiting from safe haven buying and a dispelling of fears that the US Federal Reserve might be forced to raise interest rates to contain inflation. A sharp fall in oil prices towards the $60 a barrel market further eased inflationary fears as the Fed maintained its pause in adjusting interest rates at a monetary policy meeting on Wednesday.

Emerging market assets - shares, currencies and bonds - suffered a big sell-off in reaction to a turbulent week marked by the coup in Thailand, riots in Hungary, a corruption scandal in Brazil and the collapse of the coalition ruling Poland. In South Africa, the dropping of a corruption case against Jacob Zuma, a former deputy president and popular leftist, raised talk of him becoming the country's next leader.

"Investors have underestimated political risks in emerging markets," said Kingsmill Bond, strategist at Deutsche Bank.

Emerging markets were also weighed down by concerns over their sensitivity to a US economic slowdown. Some analysts said emerging market assets had been hit by investors taking "risk off the table" ahead of the month and quarter-end on September 30. Hungary was one of the hardest hit after the scandal over an admission by Prime Minister Ferenc Gyurcsány that he had lied to voters. The country's stock market benchmark, the BUX index, fell by 6.56 per cent while the currency dropped 2.2 per cent.

Thailand was more resilient, with investors seeming to buy into weakness. The SET index fell 2.7 per cent after re-opening from Thursday. The baht lost 0.3 per cent. In Turkey the ISE 100 index lost 4.6 per cent over the week and the lira 3.8 per cent.

Lars Christensen, senior analyst at Danske Bank, said emerging markets might be in for a new sell-off that could be as severe as May's.

He said the risks looked largest in central and eastern Europe, where political uncertainties have risen sharply and external economic balances were relatively weak. Exposure should also be reduced to high-volatility markets like South Africa and Turkey.

However, he said there was no reason for a sell-off in Asian emerging markets where external balances looked robust, even in Indonesia.

"Asian emerging markets could be seen as a safe-haven in these volatile times," he said.

Philip Poole, strategist at HSBC, said emerging markets faced two competing factors. One was was the increased risk from a slowing of the US economy. However, they also benefited from the lower bond yields that resulted from this as they would increase the appeal of carry trades - borrowing in low-yield currencies to invest in higher return assets elsewhere.

The evidence of the US economic slowdown came starkly in the Philadelphia Federal Reserve's August business conditions index that showed its first negative reading for three years.

This helped Treasuries surge over the week with investors starting to look to cuts in US interest rates next year. Yields on the 10-year note fell by 18 basis points to 4.61 per cent.

The economic gloom put US equities under pressure. By mid-afternoon on Wall Street, the S&P 500 index was down 0.5 per cent on the week; the Nasdaq 1 per cent and the Dow Jones Industrial Average 0.6 per cent.

Europe was relatively resilient, boosted by takeover activity. After hitting a four-month high on Thursday, the FTSE Eurofirst 300 index ended down 0.2 per cent over the week.