Sucheta Dalal :Cautious Investors Mount a Retreat
Sucheta Dalal

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Cautious Investors Mount a Retreat  

June 2, 2006

World Markets Pull Back From Highs On Inflation Fears


By Nell Henderson and Brooke A. Masters

Washington Post Staff Writers

Saturday, May 27, 2006


Many investors have been pushing their "sell" buttons in recent weeks, shedding global stocks, debt and other assets on fears of rising inflation, higher interest rates and slower economic growth this year.


This marks a reversal for hedge funds, mutual funds and other big market players whose enthusiasm earlier this year helped push prices up sharply for oil, copper and other raw materials; U.S. stocks; and riskier assets in developing economies, or "emerging markets."


Oil traded above $75 a barrel in late April, and the Dow Jones industrial average hit a six-year high in early May. At its peak on May 8, Morgan Stanley Capital International Inc.'s emerging-markets index was up 25 percent this year.


Those lofty prices reflected investors' expectations then that the world's major central banks would nudge interest rates up a little this year, keep inflation low and fuel continued healthy global economic growth. But signs of climbing consumer prices have clouded that profitable scenario, roiling financial markets and driving asset prices lower worldwide.


U.S. benchmark crude oil fell below $69 a barrel a week ago, before rebounding to close yesterday around $71 a barrel; the Dow closed yesterday 3.7 percent below its recent high close; MSCI's emerging-market index has dropped 13 percent since its peak, while the major stock indexes for Japan, Europe, Brazil and many other economies are lower than they were a month ago.


"This is a scare about growth," said James Swanson, chief investment strategist for MFS Investment Management Inc., which runs mutual funds and also manages pension funds. "This is a psychological pullback."


Many in financial markets fear that faster inflation may prompt the Federal Reserve and its counterparts in other major economies to push interest rates significantly higher than investors had expected this year, leading to slower growth, according to fund managers and traders.


The concerns began building after the Fed raised its benchmark short-term rate May 10 and indicated that it might lift it higher in June. They deepened on May 17, when the Labor Department reported that U.S. consumer inflation had picked up in April, for a second month in a row, strengthening expectations that the Fed will hike rates again.


Adding to the jumpiness in financial markets is uncertainty about how successfully the Fed's new chairman, Ben S. Bernanke, will handle this challenge, traders say. Some investors worry that the rookie Fed chief is already behind the curve in combating inflation; others worry that he'll raise rates too much.


Financial markets also expect interest rates to rise this year in Europe and Japan. But investors don't know how high rates will go, how those increases will affect the relative value of currencies in various economies or whether China will follow up on promises to let its currency rise in value, said Bill Gross, managing director of Pimco, Pacific Investment Management Co.


There is "a lot more uncertainty now as opposed to a few months ago," Gross said. "That's why you're seeing all this volatility in the marketplace."


Traders and fund managers say they haven't seen signs of stress in the financial system so far but agree there is always a risk of serious turmoil -- as happened in 1998 when a Russian debt default pushed a U.S. hedge fund to the brink of collapse and caused the U.S. bond market to almost cease functioning. Adding to the current volatility, analysts said, is fear that the bird flu could prompt an economic crisis in Asia.


And as borrowing costs rise, heavily leveraged investors grow more vulnerable, Gross said. "No doubt, there is more [systemic] risk today than six months ago."


A factor in the current situation is that the prices of stocks, bonds, raw materials, real estate, collectibles and other investments rose in recent years while central banks in the United States, Europe and Japan held interest rates very low to spur economic growth, pumping more cash, or "liquidity," into the world economy.


Much of that extra money flowed into hedge funds, the lightly regulated and often heavily leveraged private investment funds for investors willing to take greater risks in search of greater returns. And relatively low rates of return in the industrialized world prompted many investors to "reach for yield," seeking better returns by putting their money into riskier investments, such as those in emerging markets.


At the end of the first quarter, hedge funds that specialized in emerging markets had $50.4 billion in assets under management, up 245 percent from the $14.6 billion in that sector three years earlier, according to Hedge Fund Research Inc. That's significantly faster than the already explosive growth of hedge funds in general. Total hedge-fund assets rose 182 percent over the same period, to $1.81 trillion from $640 billion.


Now, borrowing costs are rising. "In a nutshell, the era of easy and abundant global liquidity is coming to an end -- a change in the global monetary backdrop that usually inflicts pain on the asset class highly dependent on easy money -- the emerging markets," Joseph Quinlan, chief market strategist for Bank of America's Investment Strategies Group, wrote in a recent analysis for clients.


Much of the recent price run-ups in emerging-market assets and commodities was driven by "momentum investors," who place their money in anything going up and then sell when the price stops rising, analysts said.


"A lot of this was momentum players, just like the momentum players were in the Nasdaq six years ago because that was what was going up," said Harvey Hirschhorn, Bank of America's chief portfolio strategist. "As soon as it stopped going up, they headed for the hills."


And hedge funds had done well this year until May, Gross said. Now that they "see a little bit of risk at the fringe, they pull back to lock in their gains for the year."


-- Sucheta Dalal