Why did so many world markets sell off on Tuesday?

On the surface, there are similarities to the Asian crisis of 1997, which gave markets the word “contagion” – financial and currency crises spread from one country with weak economic fundamentals to another, until European and US markets also suffered. This time, however, several analysts suggested that the cause was slightly different. Rather than contagion starting in China, where markets fell 9 per cent on Tuesday, they suggested that there was a correlated fall that involved many different assets that appeared over-valued and, therefore, unattractive for investors who had become more nervous about economic risks.

One senior trader said: “The global macro backdrop to all of this is that almost every asset is more highly correlated to every other. Chinese consumers and Joe Public in Detroit are no longer as dissimilar as they used to be.” He added that the continued proliferation of hedge funds that are able to trade in greater volumes, and more nimbly, allow the same players to be involved in many diverse assets at the same time. Although apparently unconnected, their returns are in fact correlated, and so a signal to sell from hedge funds’ quantitative models can exacerbate both movements and correlations. He said that Tuesday’s drama involved “a whole series of traders unwinding a whole series of trades”. He added: “Although it might not have felt like it in the chaos of Tuesday, I think what happened was an orderly repricing of risk. This was not a 9/11 for the markets.”

David Bowers, managing director of Absolute Strategy Research in London, said that correlation between asset classes was increasing. He drew a comparison be-tween investment in China and the “bubble” in tech stocks in 1999 and 2000. “China could grow at 10 per cent forever. But people forget that the consumers of their products are essentially cyclical. And they are, essentially, US consumers. “US demand has come in weaker than expected. Maybe the China story and the subprime story are linked,” he added. “The weakness in housing is going to cause real problems in the supply chain to the US consumer – and that could be US small-caps, or it could be in Asia. The saying these days is that the only thing that goes up when the market goes down is correlation.”

Alan Ruskin, currency strategist at RBC Greenwich Capital Markets, pointed to the dangers earlier this week. He said: “It is a measure of how taut risk appetite nerves are, that market participants are asking questions whether the travails in the subprime market and the Indian equity will some how converge to become something bigger?” He added: “The inter-linkages from Harlem to Shanghai by way of Mumbai are weak, but unlike prior years are not non-existent. I do not see anything in this that is the catalyst for a more concerted shake-out, even if short-lived shake-outs in rich markets have been triggered by less.”

This article is a Financial Times article