Quotes of the Day

Financial markets around the world have been lurching around on a roller coaster over the past couple of weeks, but in few places has the ride been as stomach-churning as in India. On May 22, India's Sensex stock index plunged 10% in just two hours, triggering an automatic halt in trading, vaporizing more than $35 billion in wealth and sparking nationwide calls for calm. "My advice to retail investors is to stay in the market," pleaded Finance Minister P. Chidambaram. Those who did were rewarded in the following days as share prices rebounded, but at the end of a turbulent week, the Sensex was down 15% from its May 11 peak—a drop that many had reckoned was overdue. "People were getting so bullish, they thought there was no risk in buying equity. But there's always a risk," said Rakesh Jhunjhunwala, a renowned Bombay-based investor often referred to as the Warren Buffett of India.

Indeed. If there is one single theme underlying the extraordinary market gyrations of recent days, it is this: investors are suddenly rediscovering the laws of gravity. For much of the past four years, the only direction for most markets worldwide was up. Fueled by cheap credit and a booming global economy, prices for everything from Turkish stocks and Moscow real estate to aluminum futures and junk bonds have been rising and sometimes soaring. Copper has jumped more than 80% this year alone, while the Vietnamese stock market is up 78%. Even after the recent skid, the Indian market is up 134% in the last two years.

Blue-sky optimism has now abruptly given way to a serious case of the jitters. One clear indication: a "global risk appetite index" compiled by the investment bank Credit Suisse First Boston. Last week, the index dropped out of the "euphoria" zone for the first time in nearly two months. The world's biggest markets—from Europe to Japan to the U.S.—have taken big knocks, but the worst damage is to be found in emerging markets that had racked up the heftiest gains, countries such as India, Indonesia, Russia and Argentina. In those places, sharp declines are feeding fears that the halcyon days are over. "This feels like a tipping point," says Andrew Clare, a finance professor at London's Cass Business School. "It seems like we are entering a new phase of global economic growth and a new capital-market cycle."

Markets are inherently unpredictable. But several of the same forces that drove them up are now destabilizing them. These factors will be critical for the future, too, helping to determine whether the four-year bull market continues, stalls or goes into reverse—perhaps taking the global economy with it. Four fear factors that bear watching:

THE COMMODITIES BOOM
Industrial metals like copper and zinc used to be the neglected stepchildren of international investment. Then along came China (and, to a lesser extent, India), with its seemingly insatiable appetite for raw materials to feed the nation's huge manufacturing operations. For a while, prices rose steadily, but in the past year they have taken off vertically as investors have piled in, chasing better returns than they can earn in more conservative investments such as bonds. Highly speculative hedge funds have driven some of the action, but stodgier institutional investors have also joined the spree. Britain's BT pension fund, for one, invested almost $2 billion of its $63 billion in assets in commodities at the beginning of this year. Rising commodity prices have lifted stock markets in countries with substantial natural resources, particularly Russia. Some now believe the inflow of this speculative money has created a bubble that's in the process of bursting. "The speed and scale of the rise in industrial metals prices seen so far in 2006 is extremely hard to justify on fundamental grounds," frets Tony Dolphin, director of economics and strategy at Henderson Global Investors in London. Yet, watching China and India continue to power ahead, many still believe there's room for prices to keep rising. HSBC last week raised its forecast for the average price of copper this year by 40%.

THE INFLATION THREAT
Rising commodity prices ring alarm bells among investors and central bankers because they often herald an increase in inflation. Take the French company Nexans. It's one of the world's biggest manufacturers of electricity cables, which are made principally out of copper. With metal prices surging, the company has had little choice but to pass on increases to customers, and chief executive Gérard Hauser worries about how long that can continue. "If the markets don't calm down, the world economy will slow," he says. In the 1970s, oil-price hikes quickly fed through into inflation. So far, a renewed surge in the cost of oil to more than $70 per barrel and higher prices for a slew of other commodities hasn't led to a big inflationary bump. One key reason: wage increases in many countries remain moderate. In its economic outlook published last week, the 30-nation Organization for Economic Cooperation and Development (OECD) predicted that inflation will remain "relatively benign" over the coming year. Others are less sanguine, and think it's only a question of time before inflation starts to pick up noticeably. Andy Xie, chief regional economist at Morgan Stanley in Hong Kong, says that the current volatility "is a rehearsal for the real crash, which will come when the [U.S. Federal Reserve Bank] finally realizes it has an inflation problem."

HIGHER INTEREST RATES
Central banks try to zap inflation by raising interest rates. Over the past two years, the Fed has steadily raised its rates to 5%, and the general assumption was that the hikes would soon end. But nobody is so sure any longer. Recent U.S. inflation data was worse than expected, helping to trigger the market turbulence. Investors are now torn between those who believe the Fed's new governor, Ben Bernanke, will continue raising rates to impose his authority and stamp out any chance of an inflationary revival, and those who argue that rates are already too tight. That risks choking off economic growth and spooking investors in both stocks and real estate. The European Central Bank, which raised its rates last December, has been hinting that it may soon tighten credit once more. Even in Japan, which has kept its rates at zero for much of the past five years, there is now widespread speculation that the Bank of Japan may make some moves later in the year. One consequence of higher interest rates is that it prevents investors from borrowing money at cheap rates to speculate on stocks. That may help to cool some of the market fever. But the unsettled interest-rate environment is helping to feed volatility, says Hon Cheung, managing director of State Street Global Advisers in Singapore: "Things are less clear than they were two months ago."

SLOWER GROWTH
Booming Chinese growth of almost 10% a year and continued big spending by U.S. consumers have powered the strongest global economic expansion in three decades. If that engine slows—and any of the factors above could throw a wrench in the works—stocks and other assets in many countries may suddenly seem radically overpriced. China alone accounted for 30% of the total increase in Japanese exports between 2001 and 2005, giving Japan's overall economy a long-overdue boost. In the fourth quarter of 2005, Japan posted annualized growth of a sizzling (for the world's second-largest economy) 5.5%. So far, there is little sign of a slowdown in China, even though the government has taken some steps to curb soaring property prices and cool investment in overheated industries. Investors can count on "continued strong demand for commodities from China in the future," says Guo Guangchang, chairman and chief executive of Fosun, a Chinese conglomerate with operations in property, steel, and pharmaceuticals. The OECD thinks the U.S. will remain robust, too, although it might slow a bit, to a forecast 3.1% growth rate next year from an expected 3.6% this year. And Europe is finally showing signs of picking up steam, joining Japan in ensuring that the world economy stays on track. Still, warns the OECD, "if anything the risks have increased," especially regarding big imbalances in trade and current accounts and uncertainty over long-term interest rates.

So who's right—the optimists or the pessimists? In Bombay, famed investor Jhunjhunwala has no doubt. "I am absolutely confident in the Indian economy," he says. How about the theory that the big run up in Indian stock prices was simply a bubble that's now showing signs of bursting? No, he says adamantly, "I don't invest in bubbles." Then again, nobody does. At least, not knowingly.

• Peter Gumbel | Paris
• A sharp drop in global stocks reminds investors of the dangers that have been lurking beneath calm waters. A guide to these threats