Risk aversion: what’s going on in world markets?

The rout—at the time, a welcome one—began in commodities, where historic high prices drove up inflation around the world. As prices for crude oil, copper, gold, and multiple foodstuffs began falling in mid-July, consumers as far apart as China and Chattanooga breathed sighs of relief.

Unfortunately, commodities were followed by global stock markets. As the summer gave way to autumn, consumers and investors watched in shock as the Hang Seng Index on the Hong Kong exchange plunged as much as 59% from its most recent high, the Dow Jones Stoxx 600 of Europe collapsed 46%, and the Icelandic ICEX rolled off the table, losing 77% of its value in one day on October 14 and 93% by the end of that week. In the U.S., the S&P 500 lost 44% and Nasdaq 45%, much of it bitten from retirement accounts and small traders. All told, estimates of the amount of wealth chopped from global equities are currently around US $31 trillion.

Seasoned traders who withstood the crash of 1987 have admitted they’ve never seen anything like this. The worldwide collapse of commodities, stocks, currencies, and just about every other investment vehicle out there has brought uncomfortable images of 1929 to the forefront of everybody’s minds.

Is it really that bad?

It’s a truism that investment markets are driven by two emotions: fear and greed. However, since the Lehman bankruptcy that’s been changed to fear and terror.

As investors realized no vehicle was immune to the downturn, they panicked, yanking their capital from anything riskier than a mattress and repatriating funds to the safe havens of Japan and the U.S. Interestingly, this flight to quality has not generally included Switzerland, the other traditional port in financial storms, perhaps because of Swiss banks’ exposure to emerging economies, the ones currently being supported by the World Bank and International Monetary Fund.

Official Treasury International Capital (TIC) data shows that US $143.4 billion flowed into the U.S. for indirect investment in September 2008 alone, and this is even more interesting when placed in context. International investors had been limiting or removing their funds from the U.S. on fear of a domestic downturn, only to reverse course dramatically when the recession turned global, as shown below:

The demand for U.S. Treasuries, considered the safest of all safe havens, has been so high among investors both domestic and foreign that the yield has fallen to 0.01% on a three-month note. Right now, nobody cares about earning a profit; investors just want to keep what they already have.

The Volatility Index (VIX), which measures fear in the markets, averaged below 20 between its inception in 1993 and September 2008. Since then, it’s climbed as high as 89.53, with average readings consistently two to four times above normal.

We get the picture

That said, there are tentative signs of a bottom forming both in markets and the economy. Credit remains ferociously tight in consumer and commercial markets, but thawing has appeared at least between banks and should trickle down the wholesale-retail pipeline in time. The VIX remains high, but there are no signs of it climbing higher, although that could change overnight with another shock to the system, such as a bankruptcy for one of the auto makers or another major financial institution needing a bailout.

As central banks around the world slash interest rates with machetes, and governments initiate economic stimulus packages and loosen fiscal policies, the current call for the U.S. economy is a continued decline in gross domestic product through the first six months of next year. The fourth quarter of 2008 is expected to register the poorest performance, with a contraction of around −5% in comparison with the third quarter. If this call is correct, for the U.S. the worst is now, and the turn of the year may see economic indicators slowly climbing out of the basement.

Because other central banks, including the Bank of England and the European Central Bank, were behind the curve in initiating interest rate cuts (as late as June 2008, the ECB was still raising rates), the economic recovery will probably be slower on that side of the Atlantic. Canada and Australia may escape a technical recession, but the specter of deflation still hovers over Japan.

It’s not a pretty picture. But it’s still a far cry from 1929.