Will global capital markets now follow Arabian bourses lower?

It has been said that corrections in financial markets are like tugging a brick on a piece of elastic, you keep pulling and pulling until suddenly the brick hits you in the face.

Thus the Federal Reserve can keep raising interest rates by 25 basis points each month for over a year, and nothing happens. Then all of a sudden a liquidity crisis is at hand, and investors cash out of assets that look very expensive in an environment of high and not low interest rates.

Analysts point to a withdrawal of $200 billion by the Bank of Japan earlier this year as another important liquidity squeeze. Dr. Marc Faber has also recently highlighted a slowdown in the growth of oil revenues in 2006 as an explanation for the stock market sell-off in the Arab world this year.

Market panics

The problem is that markets tend to overshoot on the upside and undershoot on the downside. This is the classic phenomenon of investors all rushing to exit assets at the same time, producing a panic and depressing prices beyond fair value.

So while the summer is traditionally a quieter period for capital markets, many analysts are nervously eyeing the outlook for the autumn. October is the usual month for stock market upsets, and the odds in favor of this year being a black period are shortening.

The only reason to step back a little is that here we are in late June saying this, which gives the Federal Reserve plenty of time to do something about it well in advance. The US electoral cycle also favors intervention in markets at this point.

So perhaps as early as next month expect to see a sign of a more accommodative stance by the Fed, and as Standard Chartered Bank's regional chief economist Steve Brice told journalists in Dubai this week, it would only take a few words to devalue the US dollar by 10-15 per cent.

US dollar devaluation

For in truth, the markets have two ways to adjust to the current global imbalances: a stock market crash and lower real estate prices; or US dollar devaluation. The latter is far less painful to US citizens, and so looks most likely.

On the other hand, sudden shifts in the value of the US dollar have also been known to spook investors, so clearly this is a time to tread wearily. It might also be a moment when stocking up on precious metals is advisable as a hedge against US dollar weakness, especially with gold and silver prices having undergone a recent correction.

However, it is certainly true that the sharp falls in Arab stock markets this year have been followed by turbulence in global markets, and we may not have seen the end of it.