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From inflation-pressured China and other emerging markets to debt-rattled Europe and a consumer-challenged U.S., all signs point to a global slowdown of serious dimensions. Economists like to call this a "soft patch," implying that we may get a little mud on our wheels, but we won't be stuck for long.

Olivier Blanchard, the International Monetary Fund's chief tea-leaf reader, last week described the deteriorating U.S. situation - weak job growth, a dismal housing outlook, exhausted consumers still trying to get out from under heavy debts - as "a bump in the road, rather than something more worrisome."

If that's true, it's a heck of a bump. But maybe the U.S. looks pretty good to the IMF brain trust these days, when compared with the euro zone, which is sucking in billions from the world's lender of last resort to keep little Greece from bringing down a big chunk of the European banking system and the euro along with it.

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To get a gloomier assessment of American prospects, we need look no further than the darkening crystal ball of David Rosenberg, Gluskin Sheff's eminent chief prognosticator, who puts the chance of another U.S. recession by the end of next year at 99 per cent.

Then there is the raft of global economy experts still clinging to the middle of the bumpy road. "The pattern of very weak recovery in the advanced economies and strong but slowing growth in the emerging markets is going to be the theme of the rest of this year," Cornell University professor Eswar Prasad tells me.

But it's plain from the way the markets have been behaving in recent weeks that jittery investors think this so-called soft patch is more like quicksand.

When faced with too many of what Donald Rumsfeld famously called known unknowns and unknown unknowns, market players don't just retreat from what they perceive as direct risk flowing from whatever financial or economic woes are roiling some part of the world. They shy away from riskier investments of all types. This flight to quality shows up quickly in bond and currency markets, as money pours into such traditional safe havens as U.S. Treasuries and Swiss francs. If the jitters persist, it will also show up soon in a pronounced shift toward large-cap stocks and away from the small-cap sector, even if the smaller companies are completely insulated from whatever is causing the latest crisis of confidence.

That's the unexpected finding of a study into U.S. market responses to eight crises in emerging markets from the early 1990s to 2007.

"What we saw was that investors pulled back from higher-risk areas, but not necessarily those related to the country of origin [of the crisis]" says Dave Berger, co-author of the study and an assistant professor of finance at Oregon State University.

"We would expect that stock markets in two different but related economies would crash at the same time," Mr. Berger says. "But we found that during big market crashes, investors adjust their holdings towards bigger corporate stocks that they perceive as being safer, even after controlling for economic exposures."

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Previous studies had shown no particular impact from the external crises of the past 20 years on the performance of the U.S. market - at least prior to the global meltdown of 2008, when there was nowhere to run. But that's because researchers focused on aggregate numbers, rather than internal portfolio shifts designed to reduce risk. On average, the markets didn't move, but the riskier stocks took a pummelling.

Intriguingly, those also tend to be less liquid - and hence harder to trade in a hurry - than the bigger names. "We think liquidity [needs]could play a role if a shock in one market generates, say, a margin call," says Mr. Berger, himself strictly a long-term investor who ignores short-run volatility. "You might meet that margin call by trading your more liquid securities. We expected that, but we didn't see a lot of evidence for the liquidity story."

The findings should serve to remind investors that there are few places to hide from a financial or economic storm, regardless of where it occurs. Portfolios can take a severe hit even when none of the stocks involved has any obvious link to the crisis.

It seems reasonable to conclude that an eruption today in Europe or China or simply a sharp global downturn could trigger the same sort of reaction in any market, no matter how healthy the domestic profit picture. "We happened to focus on emerging markets. But it sure looked like investors were scaling back risky positions everywhere and then looking for the safer alternatives," says Mr. Berger, whose research appears in the latest issue of Global Finance Journal. "I'd expect a similar flight from risk regardless of the origin of the crisis."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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