Jittery investors run for safety

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The rally ran into reality Tuesday, as escalating unrest in Libya and across the Middle East sent investors running for shelter from a market that is suddenly much less comfortable with risk. "We've been priced for perfection. Now we're seeing that the world isn't perfect after all," said David Rosenberg, chief economist at Gluskin Sheff + Associates Inc.

Stock markets fell across the board, with Toronto's S&P/TSX composite index dropping 1.1 per cent and the benchmark S&P 500 index in the United States shedding 2.1 per cent. The VIX index, a measure of the stock market's volatility that's often taken as a proxy for the level of investors' fear, jumped more than four points to 20.80, its highest reading since early December and its biggest percentage rise in nine months. Meanwhile, investors headed for the safety of government bonds, bidding them higher and sending the interest rate on the 10-year Canadian government bond to a three-week low.

Commodities sensitive to economic risk slumped, led by copper, down 3.6 per cent. Investors flocked to the traditional safe havens of gold and silver, pushing both precious metals higher.

A similar pattern played out in the foreign exchange market, where investors sold the higher-risk, cyclically sensitive currencies - including Canada's - in favour of the traditional safety of the U.S. dollar.

Market watchers said the Libyan situation is injecting a dose of fear back into markets that in recent weeks were all but ignoring risk in their march higher.

"The resiliency of the equity rally in the past four to six weeks has been very surprising," said Vincent Delisle, market strategist at Scotia Capital in Montreal. He noted that stocks had continued to rally despite clearly overbought prices, rising Middle East tensions and mounting inflation fears. Meanwhile, the VIX had declined to near 3 1/2-year lows, indicating the biggest risk appetite among stock-market investors since before the credit crunch.

"People have been looking for an opportunity to reduce risk a little," Mr. Delisle said. "Libya seems to have done it."

Economists and market watchers say it's much too early to take the Middle Eastern troubles and investors' pullback as evidence of a troubled global economy or a coming downturn in the financial markets.

"I don't know if you can overemphasize that a lot of asset markets were overstretched," said David Watt, senior currency strategist at RBC Dominion Securities. "Right now, it's just a profit-taking exercise … You just got a sense that there was going to have to be a clean-out of risk positions in many asset classes."

However, he acknowledged, "there's a lot more uncertainty today than there was a few weeks ago."

Mr. Delisle suggested the stock market may now have "a recipe for a short-term pullback," as the geopolitical uncertainty comes at a time when the market is about to enter a slow period for earnings reports, starving investors of fresh information on corporate profits. But he believes that increasing amounts of institutional investors' cash returning to the equity market, as well as growing U.S. consumer confidence and generally positive earnings in the latest quarter, should keep any stock market decline to modest dimensions.

In contrast, Mr. Rosenberg believes the smooth sailing of the year to date is destined to hit rocky waters, as investors become re-acquainted with risk. If the political upheaval were to spread to the region's biggest producer, Saudi Arabia, he could see oil prices topping $200. But even without such a severe spike, he argued, rising oil prices already pose a major risk to the global economic recovery.

"If you look at it historically, whenever oil is up 120 per cent over a two-year period, a global recession ensues," he said. Two years ago, oil was under $40 a barrel.

"We had six mini-bull and bear markets last year - and we probably have a calendar [in 2011]more full of event risks than last year," he said.

"If you thought last year was a roller-coaster ride, this year is going to be Space Mountain."