Investors cope with new economic risks

Despite a generally strong world economy, stock-market declines here and abroad this week are confirming a new investor mood that's focused less on hoped-for highs and more on the downside risks.

Many stock indexes remain up for the year to date, but in the past month they have shifted sharply downward, led by the emerging nations that had been posting the strongest gains.

From May 8 through this Monday, for example, the MSCI Emerging Markets Index has fallen 13.8 percent, the Russell 2000 index of small US stocks is down 8.7 percent, and the Standard & Poor's 500 index of large US stocks have shed 4.5 percent of their value. Similarly, a broad index of major foreign stocks, from Europe to Japan, is down about 5 percent.

Wednesday morning, after sell-offs in China and Japan earlier in the day, traders pushed the Dow Jones Industrial Average back and forth across the psychologically important 11,000 mark.

Topping the list of risks is the threat to the overall pace of global economic growth, as the US Federal Reserve and other central banks raise interest rates to combat inflation. Some fear that rising interest rates could cause a recession. Many see that scenario as unlikely, but still fret that slowing growth could dampen corporate profits.

"The sell-off in risky asset markets has been global," Richard Berner, an economist at investment powerhouse Morgan Stanley in New York, wrote to clients late last month. "Until recently, many investors were hoping for the Goldilocks scenario of just enough growth to sustain earnings, credit quality, and brisk demand for commodities, but not enough to stir inflation and more Fed tightening."

The current climate, by contrast, has brought a range of potential risks to the forefront. Dangers include the possibility of a sharper-than-expected downturn in the US housing market, a continued slide in the value of the US dollar, an interest-rate overshoot by inflation-wary central banks, and some unforeseen financial crisis in the murky but massive realm of hedge funds.

This doesn't mean that a market meltdown is coming. But it's been enough to ramp up volatility on trading floors from New York to Bombay.

In essence, the global economy has entered a phase where its momentum is harder to read. Many forecasts call for world gross domestic product to continue growing at a healthy clip of about 4 percent this year. But recent signs in the world's largest economy are troubling. US inflation is edging up, even as job creation - a key driver of future growth - faltered in May, according to a report last Friday.

Mr. Berner, for his part, suggests that concerns about a US economic slowdown are overblown. He predicts a resumption of solid growth during the summer.

"Until that resilience restores confidence in the outlook, however, investors may continue to reduce risk in their portfolios," he said in his May 24 commentary. He calls this move the "risk-reduction trade."

Translation: Sellers could dominate financial markets for a while, especially in riskier regions and sectors. Cash looks increasingly attractive to some investors, given concerns that rising interest rates could hurt both stocks and bonds.

Shares in Japan and Thailand fell to six-month lows Wednesday, while South Korea's market dropped 2.7 percent, for example. China's Shanghai composite index of stocks posted its largest one-day drop in more than four years, meanwhile, although analysts attributed the 5.5 percent sell-off mainly to traders who wanted to build cash to buy new stocks that will begin trading soon.

The new focus on market dangers was captured, in an oblique way, in Business Week's latest cover headline: "Mr. Risk goes to Washington" was the magazine's take on President Bush's choice of Henry Paulson, the chief executive of investment house Goldman Sachs, to run the Treasury Department.

The thesis is that Mr. Paulson brings a refined understanding of risk and rewards to that important job - but also that the times demand such skills. He will have to cope with worldwide concerns about the dollar - will it fall too far or not far enough? - and about whether the governments of industrialized nations can afford to pay health and pension benefits without fueling inflation.

Those concerns, and not just the shorter-term uncertainty about central bank policies, are part of what's rattling investors these days.

Some analysts suggest the dollar needs to fall gradually against the currencies of US trade partners to shift patterns of commerce into better balance.

But with the US as the world's leading consumer nation, others - including exporters from Beijing to Berlin - worry that any "weak dollar" policy could destabilize the world economy. And a weaker dollar, they argue, won't by itself correct America's gargantuan trade deficit with the rest of the world.