Research Note - State Street Global Markets, 10 July 2008
State Street is the world's leading provider of financial services to institutional investors including investment servicing, investment management and investment research and trading. With $15.26 trillion in assets under custody and $1.89 trillion in assets under management at July 2008, State Street operates in 26 countries and more than 100 geographic markets worldwide.
Specialisms
- Capital Markets
- Asset Management
- Alternative Investments
- Wealth Management
When the president of the San Francisco Federal Reserve speaks of "three ghastly witches" haunting the US economy it is probably worth paying attention. Janet Yellen and other Fed speakers are generally known for their moderate tones, so invoking Shakespeare's harbingers of doom is a little out of the ordinary. However, her actual remarks struck a similar note to the assessment of economic risks from the last FOMC statement.
This balance has been notably absent in commentary from other quarters. Rather than three witches, many are now sighting four horsemen galloping relentlessly over the horizon. It has certainly been an ugly week for news. Yellen's concerns over housing, the financial sector and cost- push inflation from high commodity prices have been to the fore on both sides of the Atlantic. In such an environment it is the shrillest voices that get heard and there have been some pretty apocalyptic prognostications to accompany the official inauguration of a bear market in the US.
State Street Global Markets' measures of institutional investor flows offer a different signal. They reveal how the silent majority is actually reacting to the current outpouring of bad news. Risk seeking has been pared back, but developed equity markets are still being seen as relative safe havens even as emerging markets exposure continues to be cut. This is typical of the pattern of flows in the Safety First regime.
Of Yellen's witches, in the medium term at least it seems inevitable there will be more bad news from the housing and banking sectors. Markets are by now becoming inured to record-breaking house price falls in the US. The same horror show is now being reprised in the UK, Ireland and Spain. The stress in the financial system is also all too plain, with the iTraxx Europe index trading almost at peak crunch levels of 109bp earlier in the week and bank CDS widening has been dramatic.
The best hope for markets may be good news on the inflation front. The oil price has become a barometer of inflation fears and to some extent market sentiment. When oil fell sharply on Tuesday equity markets rallied and European bourses held on to those gains on Wednesday. Oil is rising today and markets in Europe and the US are down. The good news, however, is that if oil is stripped out the so-called commodities super cycle is looking decidedly tired. The Reuters-CRB Index is actually in reverse . This index is a better measure of broad commodity prices than other indices which are heavily skewed toward energy.
Flows also indicate that institutional investors are increasingly sceptical about the commodities boom. The correlation between equity flows into the world's biggest exporting nations peaked in April at 40%. Chile, the world's biggest exporter as a percentage of GDP, has seen one-month institutional investment flows fall from the 68th percentile (flows higher only higher on 32% of one-month periods in the 11-year history of the Cross-border Equity Flow Indicator) to the 49th percentile. One-month flows into South Africa,the third largest exporter as a percentage of GDP, are languishing in the 17th percentile (flows higher on 83% of one-month periods).
Flows also show that appetite has faded for the global Energy sector. For Materials buying in early June over the month has turned to selling now. Speculative investors on the Nymex futures market have also wound down their long positions in oil futures, having started to get queasy at the $127 per barrel level. If investors are right and commodity prices are liable to full further, one of Yellen's witchy trio, cost-push inflation, would go up in a puff of smoke.
Some moderation in commodity prices would seem inevitable after they had their best first half since 1973, the year of the oil price shock and Yom Kippur war. But it is also simple economics. If food prices go up, farmers will grow more crops. Another option is to consume less, in the OECD for example oil demand actually fell year-on-year to the end of May. The macro backdrop also makes falling commodity prices more likely. Slowing growth and booming commodity markets are not generally compatible.
The other force which should moderate inflation is witch two, the dysfunctional financial sector. Credit crunches are always disinflationary. The role of Shakespeare's weird sisters is to create confusion by offering half-truths. Headlines about an impending economic apocalypse are similarly misleading. They will be plenty of hurly-burly this summer, but there are chinks of light. If commodity prices fall and inflation fears moderate it gives central banks freedom of action. Monetary stimulus would provide a witches brew that markets should appreciate.
State Street Global Markets' measures of institutional investor flows offer a different signal. They reveal how the silent majority is actually reacting to the current outpouring of bad news. Risk seeking has been pared back, but developed equity markets are still being seen as relative safe havens even as emerging markets exposure continues to be cut. This is typical of the pattern of flows in the Safety First regime.
Of Yellen's witches, in the medium term at least it seems inevitable there will be more bad news from the housing and banking sectors. Markets are by now becoming inured to record-breaking house price falls in the US. The same horror show is now being reprised in the UK, Ireland and Spain. The stress in the financial system is also all too plain, with the iTraxx Europe index trading almost at peak crunch levels of 109bp earlier in the week and bank CDS widening has been dramatic.
The best hope for markets may be good news on the inflation front. The oil price has become a barometer of inflation fears and to some extent market sentiment. When oil fell sharply on Tuesday equity markets rallied and European bourses held on to those gains on Wednesday. Oil is rising today and markets in Europe and the US are down. The good news, however, is that if oil is stripped out the so-called commodities super cycle is looking decidedly tired. The Reuters-CRB Index is actually in reverse . This index is a better measure of broad commodity prices than other indices which are heavily skewed toward energy.
Flows also indicate that institutional investors are increasingly sceptical about the commodities boom. The correlation between equity flows into the world's biggest exporting nations peaked in April at 40%. Chile, the world's biggest exporter as a percentage of GDP, has seen one-month institutional investment flows fall from the 68th percentile (flows higher only higher on 32% of one-month periods in the 11-year history of the Cross-border Equity Flow Indicator) to the 49th percentile. One-month flows into South Africa,the third largest exporter as a percentage of GDP, are languishing in the 17th percentile (flows higher on 83% of one-month periods).
Flows also show that appetite has faded for the global Energy sector. For Materials buying in early June over the month has turned to selling now. Speculative investors on the Nymex futures market have also wound down their long positions in oil futures, having started to get queasy at the $127 per barrel level. If investors are right and commodity prices are liable to full further, one of Yellen's witchy trio, cost-push inflation, would go up in a puff of smoke.
Some moderation in commodity prices would seem inevitable after they had their best first half since 1973, the year of the oil price shock and Yom Kippur war. But it is also simple economics. If food prices go up, farmers will grow more crops. Another option is to consume less, in the OECD for example oil demand actually fell year-on-year to the end of May. The macro backdrop also makes falling commodity prices more likely. Slowing growth and booming commodity markets are not generally compatible.
The other force which should moderate inflation is witch two, the dysfunctional financial sector. Credit crunches are always disinflationary. The role of Shakespeare's weird sisters is to create confusion by offering half-truths. Headlines about an impending economic apocalypse are similarly misleading. They will be plenty of hurly-burly this summer, but there are chinks of light. If commodity prices fall and inflation fears moderate it gives central banks freedom of action. Monetary stimulus would provide a witches brew that markets should appreciate.
