Horrors may hit before Halloween
Things are looking dicey as the financial hurricane season starts, writes Anatole Kaletsky
September 05, 2006
AS businessmen, financiers and central bankers return to their full workload after a long and generally uneventful (northern) summer holiday, many will be struck by a paradox.
It is now even clearer than it was before the summer that the world economy is entering a serious slowdown, with inflation still far from under control.
Yet stock market investors around the world seem a lot more confident than they were two months ago.
So what has happened to the fears of recession and inflation that so rattled financial markets in the early summer? They have not simply vanished.
The sharp decline of the US housing market, while it was fully predictable and widely predicted, could nevertheless get out of hand.
The most probable scenario may be that the US economy will manage a soft landing after its housing boom, in the same way as many other countries - for example Britain, Australia, Ireland, Sweden and Denmark - but there are at least two persuasive reasons to believe that America may be less lucky and sink into a serious recession.
The first is that America is so much bigger than any other economy and therefore will not be able to rely on the boost from global growth serendipitously enjoyed by these other countries just when their housing markets slowed down.
The second is that inflation in America is now much higher than it was in Britain when the housing bubble deflated.
As a result, the Federal Reserve Board will be unable to support the economy with monetary easing.
Or, if it does so, inflation will accelerate even further, undermining the credibility of the Fed and the dollar and threatening America with the horrible combination of stagnation and inflation last experienced in the late 1970s.
There will be plenty of opportunity in the months ahead to assess all these possibilities in greater detail.
For the moment, I want to say only that these are genuine risks and consider the possible financial responses.
While the world economy is treading this narrow path between recession and inflation, investors seem to be getting increasingly relaxed.
Stock market prices rose strongly around the world in August and all measures of risk-aversion and volatility have declined.
On a medium-term view this may be a perfectly rational response to the prospect of a nice, gentle mid-cycle slowdown similar to those of 1995 and 1984. But history suggests that there may be at least one more ordeal to overcome before the world economy and financial markets arrive at the bullish promised land of a "Goldilocks economy", with growth that is just right, neither too weak nor too strong.
This ordeal is the financial hurricane season that runs from late August until mid-October.
If there is going to be a financial accident of some kind on the way to the Goldilocks expansion, it is most likely to happen in the next two months.
Nearly all the greatest financial accidents - the Wall Street crashes of 1929 and 1987, Nixon's closure of the Bretton Woods gold window in 1971, the Asian currency crisis of 1997, the Mexican and Russian defaults, the attack on the French franc in 1993, the sterling devaluations of 1949, 1976 and 1992 - have occurred between late August and October.
But is this just coincidence or are there rational grounds to worry that the markets may now be entering the period of greatest risk? What forces might explain the seasonality of financial crises?
In stock markets, there has long been a plausible explanation for the tendency of prices to fall during the summer, summed up by the stockbrokers' adage, "Sell in May and go away, don't come back till St Leger Day".
(The St Leger horserace is held in mid-September).
The lore on Wall Street is that buyers should hold off until Halloween on October 31.
One possible explanation of market weakness in the northern summer and autumn, which is strongly borne out by studies of monthly stock market returns, is that selling of equities is partly a passive phenomenon, since portfolios have to be liquidated when their owners die or cash retirement cheques or make insurance claims.
These liquidations happen steadily through the year, regardless of seasons. Buying, on the other hand, requires conscious decisions and investors are less likely to make these when they and their brokers are away on holiday.
For institutional investors, low liquidity in the summer also deters big buying decisions.
Selling, on the other hand, is often driven by stops or margin calls and can actually be accelerated by thin markets.
To make matters worse, investors who feel worried over the summer but are not forced to close their positions often delay their selling decisions until liquidity returns in September.
As a result, stock markets in September and October can sometimes be dominated by a backlog of "stale bulls" trying to get out as liquidity improves - and becoming increasingly desperate if the improvement in liquidity is accompanied by a further fall in prices instead of the hoped-for bounce.
This was very much the story of the 1929 and 1987 Wall Street crashes.
But what about currency markets, where seasonal imbalances between buyers and sellers make no obvious sense? Perhaps illiquidity and empty trading desks over the summer give investors an excuse to delay making big decisions and ignore disconcerting statistics or intensifying trends.
Central bankers or other would-be manipulators can take advantage of this same phenomenon by intervening in the markets to stave off the evil day when devaluation becomes inevitable or an important stop is broken.
Most people naturally prefer to spend the summer thinking about their holidays rather than their portfolios.
But when the markets get back into full swing in the early autumn, the backlog of delayed sell decisions creates huge pent-up pressure on any asset whose fundamentals have deteriorated during the summer.
Market seasonality does not, of course, prove that a financial crisis will definitely hit this autumn.
It does, however, suggest that the period of maximum risk for investors may not yet be behind us.
If you can't wait for Halloween, St Leger Day this year is September 9.
The Times
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