Fears of eurozone sovereign risk contagion to banks, tighter monetary policy in China and surprise intraday selling by electronic trading systems united to deliver the worst week for global equities since the height of the financial crisis.
At midday in New York on Friday the FTSE All World index was down 7.9 per cent for the week, matching the five-day run in February of last year, when investors feared the worst about the global banking system.
For investors, the big question is whether the current pull-back in risk appetite represents a buying opportunity or worse is yet to come.
While economic data generally support a global recovery, boding well for corporate earnings and commodities prices, the threat of contagion from eurozone debt problems looms large over markets.
“We have two conflicting forces at work. [There is] cyclical improvement in the US economy that is encouraging and, at the same time, secular overhang that is being manifested at the moment in terms of sovereign risk, but that could be broadened to excessive debt at all levels,” says Jay Mueller, senior portfolio manager at Wells Capital Management.
“Whether you consider it a buying opportunity depends on your timeframe. I am nervous about the longer term.”
Not even news on Friday that the US economy had added 290,000 jobs last month was able to stem the tide of growing risk aversion, firmly centred around the risk that Greece could default on its debt amid rising concerns about the fiscal health of Portugal, Spain and, to a lesser extent, Italy.
Alan Ruskin, strategist at RBS Securities, says that while the US jobs data should boost risk appetite, “the big problem is that the Greek story is capable of undermining the positive impact of this data very quickly and much of the rest of the day will probably be a case of staying close to base before the weekend after a wild week”.
Tom di Galoma, head of trading at Guggenheim Partners, says: “The real issue continues to be Greece. Even though the German vote affirmed support for the bail-out plan, Greek, Spanish and Portuguese credit default swaps [measuring the risk of default] still trade poorly.”
For investors, the spectre of sovereign credit risk looms as potentially the next stage of the financial crisis, as heavily indebted governments face demands from the so-called “bond vigilantes” to start reducing their borrowing.
Volatility across equities, bonds, currencies and commodities has surged this week, as concerns about the exposure of banks to eurozone debt intensified.
On Friday, in a reprise of the financial crisis, a key barometer of banking stress, US dollar Libor, jumped 5.5 basis points to 0.428 per cent – up from 0.30 per cent in mid-April when jitters about Greece started.
“It is the return of volatility,” says David Gottlieb, principal, EMF Financial Products. “The first quarter was about low volatility and now the market needs to determine what is an appropriate level of volatility given ongoing sovereign credit concerns.”
In the early part of the year, Mr Gottlieb says, investments that do well in an environment of low volatility, such as corporate bonds and mortgage-backed securities, thrived. This week, signs emerged that some investors were unwinding these trades.
“Funding pressure has been building in the credit markets for weeks as seen by the rise in Libor,” Mr Gottlieb explains.
With just $2.5bn of global investment-grade corporate debt brought to market in the past five days, this marks the slowest week for the issuance of corporate debt since May 1990, according to Thomson Reuters.
As issuance dried up, the cost of default protection, which had already surged for sovereigns, began to rise for investment grade corporations and banks in both Europe and the US.
A rising cost indicates greater risk of default.
Investors have also halted a stunning rally in junk bonds, which had culminated with the two largest months of global new issuance in March and April.
“The character of the high yield sell-off has shifted from a bet on market direction to an effort to shed credit risk,” says Martin Fridson, chief executive of Fridson Investment Advisors.
Classic havens have benefited. US Treasuries rallied, sending the yield on 10-year bonds at one point below 3.30 per cent, the lowest level since late last year. Gold surged above $1,200 an ounce amid Thursday’s turmoil but fell back on Friday.
There was nowhere to hide in commodities, which fell as investors retreated from risky assets and worried that a slower economic recovery could temper demand for raw materials. The S&P GSCI spot commodity index was down nearly 9 per cent on the week, with declines extending from oil to copper.
“We know what happened in 2008. We remember it well. It’s a classic knee-jerk reaction: sell what you can,” says Michael McGlone, senior director of commodity indexing at Standard & Poor’s in New York.
Additional reporting by Gregory Meyer in New York and Anousha Sakoui in London
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