Stephen King: How a small shock upset the apple cart

Ouch. Last week's carnage in financial markets provides a classic example of the expected happening at an unexpected time. I speak to quite a few financial investors and I think it's fair to say that many of them thought a "correction" would happen at some point. Few, though, would have managed to predict the events of the past few days. Even if they'd guessed correctly which markets would suffer, not many would have been lucky enough to get their timing right as well.

When stock markets fall, people look for explanations. Among the favourites last week were rumours of more stringent controls on the Shanghai stock exchange (the stock market falls began in China), a deterioration in US economic data, and, to cap it all, masterful words from the world's leading octogenarian economic sage. Alan Greenspan, former chairman of the Federal Reserve, warned that the US might find itself in recession by the end of the year.

Imagine, though, that you'd known about these things before everybody else. Would you have predicted last week's meltdown? Somehow, I doubt it. The Chinese authorities were quick to dispel the rumours of additional controls. As for Dr Greenspan, he only said a recession was possible. He didn't suggest a recession was plausible.

To be fair, there are genuine reasons to be concerned about the US economy. At the turn of the year, US economic data mostly surprised on the upside. Recently, though, disappointment has set in. The housing market has shown renewed signs of weakness. Durable goods orders have collapsed, suggesting that companies, despite their buoyant profits, are struggling to find worthwhile investment projects. Problems in the sub-prime market have led banks to tighten up their lending practices to households. The labour market isn't as strong as it was. And, while the Conference Board survey suggests that consumers are still in buoyant mood, the University of Michigan consumer confidence survey is not so upbeat.

US economic difficulties, however, only really became clear after the Chinese stock market had already taken a tumble. While it's possible to argue that uncertainties about the US economy may have contributed to the size of the market sell-off, it's a lot more difficult to make the case that the recent US slowdown was the underlying cause.

It seems to me that most investors have been waiting for a moment such as this. Many have taken the view that there is simply too much "liquidity" sloshing around the system, a factor that apparently explains why all manner of asset prices have risen rapidly in recent times. Seemingly, anything with a yield or prospective capital gain is worth buying. I hear from one source that Kazakhstan bonds are all the rage. Faced with bucketloads of cash, investors can choose to invest in anything: anything, that is, other than cash itself.

If, though, someone comes along and turns the cash spigot off, the whole story is in danger of going into reverse. Investors suddenly realise they have to exercise a greater degree of discretion. They have to be more selective over the assets they choose to buy. They become more risk-averse.

What, though, is "liquidity"? It's a rather unsatisfactory concept, a bit like the mysterious ether that was supposed to fill all the bits of the universe devoid of stars, planets, comets, asteroids and the like. For some, liquidity results from overly loose monetary conditions. Central banks set interest rates at too low a level, and the rest of us go on a borrowing and investing spree. For others, liquidity comes from central bank intervention: rising emerging market foreign exchange reserves, which are typically invested in government bonds, are the latest version of this story.

There may be some truth in these claims. They are, though, not fully convincing. Equity prices have made strong gains in recent years, but those gains have come against a background of persistently rising short-term interest rates from the Federal Reserve. Monetary conditions may not necessarily be tight, but they're certainly not as loose as they used to be. Meanwhile, emerging market central banks are not the only source of excess "liquidity".

To understand why, it's worth thinking about why fund managers seem to be absolutely awash with cash at the moment. Emerging market central banks certainly play a role, but there's another important factor. The vast majority of companies are very profitable, yet at the same time have no particular desire to invest these profits back into their businesses. They're not convinced - and, on many occasions, neither are their shareholders - that extra capital spending is really required. In the US, for example, capital spending fell in the final quarter of last year, and the latest durable goods orders indicate further weakness to come. If companies have plenty of money but have no desire to invest, they return their profits to the shareholder, either in the form of higher dividends or share buybacks. The shareholders, in, turn, find themselves awash with cash that now needs to be invested somewhere else: hence the enthusiasm for Kazakhstan bonds.

Put another way, an absence of investment in physical machinery leads to an excess of investment in financial (and real estate) assets. Prices of these assets are bid too high, and eventually the smallest of shocks can upset the apple cart. The vulnerabilities exposed over the last week or so are not so much the result of Chinese stock market regulations or the wise words of a monetary wizard, but rather a reflection of the longer-term shifts in savings behaviour by both companies and emerging market central banks.

The liquidity story is only good while it lasts. So long as each investor believes that every other investor is being almost compelled to buy a wide range of assets because of the inflows of cash, then each investor, individually, will be happy to do the same.

Moreover, each investor can pretend the risks are low because he or she believes that every other investor knows about the underlying risks and is pricing assets accordingly. But if everyone is buying assets willy-nilly, it's difficult to argue that risk really is being priced correctly.

What sorts of things might lead to a re-pricing of risk and, perhaps, a more extended period of asset price weakness? Emerging market central banks might choose to sell dollars, undermining the world's reserve currency. Weakness in the US housing market might eventually feed through to the rest of the US economy, undermining corporate profits.

Currently, though, many investors regard Japan as being one of the most important sources of global "liquidity". After all, investors are able to borrow cheaply in yen and reinvest the proceeds elsewhere. Should the Bank of Japan raise interest rates a lot further, this particular source of liquidity would be closed off. Many see the yen's recent rally as the beginning of this process. I somehow doubt it. Rather, heightened risk aversion reduces the willingness of investors to indulge in this particular "carry trade". It's the vulnerability of investors' animal spirits, not the actions of our central bankers, that is leading to this renewed bout of market volatility. And their spirits are vulnerable because, all along, they've know that the good times wouldn't last.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com