An avalanche is almost entirely unpredictable. Despite more than a century of scientific study it almost impossible to say with any certainty whether or not an avalanche will occur. There are too many variables, including snow structure, the nature of the slope, the use of the slope by skiers, the angle of snow and the weather.
Noting the shifting preferences of institutional investors is a less dangerous pursuit than field studies of avalanches. However, both observe mass in motion. The guide used by the strategy teams at State Street Global Markets is the regime map. It categorises investor behaviour into five distinct regimes, each characterized by a unique pattern of cross-border equity flows and gradation of risk appetite. In the last month the regime has changed from leverage to liquidity abounds.
Liquidity abounds is a regime that is associated with large inflows across equity markets. As reflected by the shift, flows into developed markets over the past month are close to a record (ninety-ninth percentile). The contrast between the behaviour of investors now and at the end of 2007 could scarcely be starker. Then the map had been stuck in riot point, the most bearish regime, for an unprecedented four months. The two regimes are polar opposite. That is what the map does. It groups similar behaviour. The further apart the hexagonal cells, the more dissimilar the behaviour.
Historically there is a 47% chance of remaining in liquidity abounds next month. The next most likely regime is safety first, with a 32% probability. The regime map has never switched directly from liquidity abounds back to riot point. The forces that have driven the change in regime are complex. But, the common thread is inflation. This has prompted institutional investors to change their asset allocation mix. It has also forced policymakers to act, which has changed interest rate expectations and reinforced investor preferences.
The news about inflation, whether in Vietnam, China, the euro-zone or UK, has been relentlessly bad. The recovery in risk appetite since January was led by emerging markets. Investors were selectively buying markets with an accent on commodity producers in Latin America, such as Brazil and Mexico. This can be thought of as an inflation hedge as one of the clearest outward signs of future inflation has been rising commodity prices.
After the Bear Stearns rescue in March, risk appetite broadened and equity flows into developed markets gathered pace. But perhaps equally telling was a move to sell out of government bonds. This may have signaled that safe haven assets were becoming surplus to requirements as the risk of a systemic financial crisis faded.
But it was also an early warning that inflation concerns were rising. As it transpired this move to sell out of government bonds in the euro-zone, Japan and the US, was well timed. The rout in bond markets during the second week of June was spectacular. The fear of inflation was compounded by tough rhetoric from central banks on both sides of the Atlantic and yields shot up in line with interest rate expectations.
Equity flows, however, remain remarkably robust. Indeed, flows into developed markets are close to a record level over the past month. Flows into the euro-zone are in the ninety-ninth percentile (only higher on 1% of previous 20-day periods in the eleven-year history of the cross-border equity flow indicator). However, flows into the US and Canada in the same are rather more modest, in the forty-fifth and forty-fourth percentile respectively. This too, could reflect inflation concerns, as both the US and Canada have cut rates aggressively. The European Central Bank has stayed put and more recently gave a clear indication it will raise rates.
The other region where flows are lacklustre is emerging Asia. These economies are fighting to prevent prices from climbing into double digits. The rate of inflation in the Philippines registered 8.3% in April and Thailand's inflation has hit a ten-year high of 7%. One month on, flows into their equity markets are feeble. In, Thailand they are in the bottom decile (higher than on 90% of previous one-months in the last decade). The same is true of the Philippines and Taiwan.
Prices reflect this. World markets are down 5% since their recent highs in early May, but for the first time since the credit crisis started last August it is emerging markets where the correction has been most severe. Inflation seems to be shaping investor behaviour at the moment. As the bond rout last month shows, when mass is in motion, it is probably best to get out of the way. Just ask any Alpine skier.