Global markets have been hit by a renewed decline in risk appetite showing its face in
most markets: equity markets are falling, commodity prices are lower and investors are
running for safety in bond markets, sending government bond yields lower in ‘safe
countries’ such as the US and Germany.

What's going on?

The decline in risk appetite came in the same week as global PMI hit a cycle high pointing to robust growth and Q4 earnings have revealed impressive results with signs that the recovery is broadening to top-line growth and investment spending. This week Greece also announced austerity measures backed by the EU to prevent a public meltdown which calmed fears that Greece would be left on its own. So why now? While we cannot claim to have the exact answer, we can point to a few explanations:
  1. First of all, equity markets started the year with massive long speculative positions (see right hand chart below). This has made the market more vulnerable to bad news as the pain trade is clearly down. Long investors will also be tempted to square positions and take home profit after a strong year in 2009.
  2.  Global growth momentum is looking to fade soon which is normally a critical phase for equity markets. Although PMI new orders are at high levels, the OECD’s leading indicator is losing momentum and this is normally a pre-warning of a growth slowdown. With a lot of underlying pessimism in markets with fiscal tightening high on the agenda this adds to the vulnerability.
  3. The turmoil in European debt markets has continued to be an issue, and with the crisis this week spreading to Portugal just as things have eased off in Greece, uncertainty over the global debt problems has got further to run.

What to expect

With markets in correction time, it can be quite dangerous to try and be brave. Our equity strategist has warned of a correction since the beginning of the year and warns that more is left of the correction. In the short term, we therefore recommend keeping risk low until clarity increases again.

Lower bond yields can be justified by the uncertainty and flight-to-quality but a view on bond yields from here boils down to a view on how severe this correction gets. We do believe things will calm down again as it most often happens with these kinds of
corrections. At least it is more the rule than the exception. If that is the case, it should not
have any macroeconomic implications and we will see higher yields again when things
calm down again. If the correction turns into a longer downturn in markets, it could trigger a negative feedback loop and have negative implications on investment and hiring decisions – and hence change fair value levels for markets.