Market falls off the Chinese pig's back

Ground Floor: So far the Chinese Year of the Golden Pig hasn't lived up to its billing as a harbinger of prosperity. Hardly had the golden pig been ushered in than the Chinese stock market turned bearish, causing it to plunge by 9 per cent in a day, writes Sheila O'Flanagan.

Reasons for the fall included speculation that the Chinese government would raise interest rates and/or increase capital gains tax in order to prevent the market becoming a golden bubble. The Chinese authorities have been talking about bubbles for a while but - as we've experienced so many times ourselves in the West - enthusiastic investors are good at ignoring bubble-speak no matter who it comes from.

Nevertheless, the Chinese Central Bank has been continuously concerned about the amount of lending going on in the rapidly expanding economy and on February 25th raised the deposit reserve requirement in order to take excess liquidity out of the system. In fact the Central Bank had already raised the reserve requirement three times in 2006 as well as in January last.

No fundamental change has occurred in the Chinese economy since what has become known as Black Tuesday. It is still expected to grow by around 10 per cent in 2007, following on a 10.7 per cent expansion last year. The actions by the authorities are geared towards managing that expansion.

Unfortunately, as far as most investors are concerned, they don't like seeing potential upsides managed. The only time they like seeing central bankers dip their toes in the markets is when they're making credit easier to obtain and helping share prices to push higher.

People were surprised and are now feeling very gloomy about the knock-on effect on the rest of the world's equity markets. As analysts keep pointing out, the Chinese market is still very localised and there was no real need for other markets to follow them down. But, just like everyone piles in when markets are going up, they make a mad dash for the exit when one of them starts to go down, hoping to beat the rush but only becoming part of the stampede.

One of the problems of this week, in particular, has been investors exiting what is known as the yen carry-trade. A carry-trade is a strategy in which someone sells a low-interest rate currency and buys a higher-interest rate currency and then invests the proceeds, making a profit on the difference between the two interest rates. A no-brainer, you'd think, and many traders agree.

Over the past number of years, yen interest rates have been close to zero. If a trader sells yen and buys dollars which he then invests in five-year bonds yielding 4.45 per cent, he's in the money for as long as the exchange rate between the two currencies remains stable.

The yen carry-trade has been hugely popular, particularly with hedge funds, but the yen has now reached its strongest level against the dollar this year and traders are getting edgy.

Japanese interest rates have been climbing too, even though there's still a pick-up of 400 basis points by being in dollars. However, Japanese investors are now looking closer to home for opportunities and the net result is that US markets are feeling the strain. This coupled with that Chinese correction - or plunge or disaster depending on your viewpoint - has left them feeling very vulnerable.

Of course, just because you think you know why something has happened doesn't mean that you like it any better. And even if investors think that the markets needed a correction - analysts have been calling for one for months - doesn't mean that it's actually welcome when it happens.

At this point most people are trying to estimate how bloodied they'll be by the end of another turbulent week. Sentiment and momentum are the biggest drivers of all as far as equities are concerned. That's why markets go up even when continued gains can sometimes seem irrationally exuberant and that's why they come tumbling as soon as the chill wind of fear begins to wrap itself around the participants.

It's also why soft landings are so tricky to manage. Once an investor has the inkling that all is not well, the main focus is the exit strategy not the landing.

I've noticed an increasing number of comments about the possibility that Ireland's housing market is about to bypass the soft landing too and dish up an unwelcome dose of realism for bricks and mortar investors. Some commentators are suggesting that everyone who bought a house in the last 12 months must be feeling hard done-by now.

Certainly if you bought as a pure investment play, you will be looking at the repayments versus the rental yield and lack of capital appreciation and thinking to yourself that this was not a good trade. Obviously the rental yield versus repayments hasn't been a good trade for years but it was offset by the capital appreciation. It was only a matter of time before that became, like the yen carry-trade, too good to be true.

If, however, you've just bought your first home and you're thinking to yourself that maybe you could've picked it up a bit cheaper if only you'd waited, then stop beating yourself up. Think of the asset you've bought over the lifetime of the mortgage.

The problem with all of us is that we want everything right now. The curtains, the carpets, the coffee-machine and the capital appreciation. We've forgotten that sometimes an investment is an investment because it's for the longer term.

But that's never any consolation at the end of a black week.

www.sheilaoflanagan.net