Fears of a serious nuclear catastrophe pushed Japanese stocks far lower in Tuesday trading.
But there is another problem building, and some fear it could lead to a much more widespread crisis in financial assets.
The problem is that banks, Wall Street firms and hedge funds have built up exposures to riskier assets over the past two years. Much of the 'smart money' has been chasing bargains—bottom fishing in sovereign debt, muni debt and financial sector securities.
If sentiment turns suddenly away from risky assets, some of these investors could find that there was no market for the risk they hold. Although there is no direct connection between, say, the situation in Japan and Illinois revenue bonds, a sharp pullback in risk tolerance could see these very different asset classes decline together.
In a crisis, assets that seem uncorrelated on a fundamental or technical basis can suddenly trade together. As the saying goes, in a crisis, all correlations go to one.
It’s hard to see how this plays out. Traditionally, risk aversion leads to a rally in Treasuries—a flight to safety. But Japan is one of the biggest buyers of US government debt. If Japan pulls back from US debt to fund Japanese debt or simply because it has lost so much wealth in the earthquake-tsunami-radiation catastrophe, that could hurt bonds.
US consumers are another wild card. Consumer sentiment has been worsening for the past few months, and consumer spending has been far less than many analysts expected. A drop in the stock market—or even just the bad news from Japan—could damage confidence and spending further. This would slow down the economy—inflicting losses on banks and retailers who were counting on a swifter recovery.
The big danger, however, is fear and uncertainty. Because it becomes difficult in these crisis periods to measure who is at risk, financial institutions often require more collateral from counter-parties—a move that effectively saps liquidity from markets. Less liquidity can create selling pressure in totally unrelated assets.
At least in the short term, we’re in an era of thoroughgoing uncertainty. The question is how long it will last and how broad and deep the sell-off will be.