Risk Aversion May Spread to Junk

Investors have lately been pulling their chips off the high-stakes table of emerging-market securities and commodities. It may take some time, but as the speculative foam fizzles, risk aversion is sure to spread to the yield hunters' next favorite parking place: low quality, high-yield bonds.

In an event with symbolic significance, Standard & Poor's cut the Nasdaq Stock Market's (NDAQ) credit rating to junk Tuesday. S&P cited the Nasdaq's use of leverage to fund its aggressive acquisition spree -- namely its 24.1% stake in the London Stock Exchange.

The downgrade came on a day the Nasdaq Composite suffered its sixth straight down day, falling 0.4% to 2229.13. The Dow Jones Industrial Average dipped 0.1% to 11,419.89 and the S&P 500 fell 0.2% to 1292.08.

The S&P was aided by strength in Wal-Mart (WMT) and Disney (DIS), but restrained by weakness in Carnival Cruise Lines (CCL), Home Depot (HD) and Nortel (NT).

As the Federal Reserve attempts to restrain the economy and ward off inflation, the Nasdaq casts an eerie shadow over the markets' recovery. It didn't play much of a role in the recent run-up, reminding investors that the late 1990s stock market euphoria is not the name of this cycle's game, and that all-time highs may just not be in the cards.

"In 2000, we lived in an environment where everything was possible," says Tobias Levkovich, chief U.S. equity strategist at Citigroup. "Today everything is challenging. There is almost an element of, 'We can't be happy.'"

Over the past five years, global liquidity was so abundant, "risk" became relatively toothless. But with the U.S. presumably nearing the end of its tightening cycle, and Europe and Japan planning further rate hikes, less cash will soon slosh around financial markets. So, repricing risk makes sense.

"The nature of inflationary pressures has changed," says Philip Poole, global head of emerging markets research, and chief emerging markets economist at HSBC. "It is not inflation in prices of goods and services, but asset price inflation based on liquidity drivers. As you reduce that liquidity, it should have an effect on financial and other assets."