Why higher market volatility is the new norm
- First, the emerging world’s spreading economic slowdown is eroding a fundamental underpinning of high and stable asset prices. Gone is the notion of a steady global growth “equilibrium”, albeit at a relatively low level, in which dynamic emerging economies offset the sluggishness in Europe and Japan. Indeed, in virtually every systemically important emerging country (including Brazil, China, Russia and Turkey) growth is slowing; and, as highlighted by Mario Draghi, European Central Bank president, last Thursday, Europe is in no position to take up the slack — leaving too much of a burden on the US to act as a powerful global growth locomotive.
- Second, asset prices were high and, in some cases, in bubble territory. China is perhaps the best example of this. In a similar way to how the US pursued home ownership as a social objective a decade ago, Chinese officials encouraged broad-based participation in the stock market as part of the country’s journey towards a market-based system. And, again like the US with housing, the phenomenon resulted in a price bubble that is challenging to deflate in an orderly fashion.
- Third, two markets, unhinged by structural earthquakes, transmit periodic bouts of financial instability to others. Emerging market currencies struggle to regain their footing in the face of multiple shocks — from China’s surprise change to its foreign exchange regime to the detrimental impact of lower global growth, massive capital outflows and, for some, sharply lower commodity export earnings. Oil is facing a similar phenomenon on account of disruptions to its supply, demand and swing producer dynamics.
- Fourth, there is less confidence in policymakers’ ability to respond quickly and effectively. Part of this is due to prolonged over-reliance on central banks as the only policy game in town; and part to the migration of major global challenges away from the direct reach of the US Federal Reserve and the ECB, the two most powerful central banks. This outcome of this weekend’s G20 deliberations in Turkey will do little to counter the erosion of markets’ confidence.
- Fifth, the clear and present danger of another “right policy at the wrong time”, this time out of the Fed. America’s central bankers have good internal economic reasons to hike interest rates when they meet next week, supported by Friday’s jobs report. But, just like China’s move to a more flexible currency system last month, this right domestic measure risks adding to global financial instability at this particular juncture.
- Finally, recent market developments have reinforced concerns about disruptive pockets of illiquidity and product malfunction. Part of this is due to the regulatory and market-driven structural shrinkage of the broker-dealer intermediation role relative to end-user demand, especially when a change in consensus views leads to a broad-based desire for portfolio repositioning; and part reflects the proliferation of products, particularly in exchange traded and risk parity funds, whose promises of performance and liquidity are undermined in periods of market illiquidity.
The influence of these six factors is unlikely to dissipate soon. Moreover, they contribute to a more fundamental phenomenon — that is, the shift in the markets’ operating regime, away from central bank repressed financial asset prices and towards a process of repricing that better reflects the cyclical, structural and secular fluidity of the global system.
So far, the impact of higher volatility — both bad and good — has been contained in finance; and, so far, it has not caused any major financial accidents. But if it persists and gets more disorderly, the risk of spillbacks on to the real economy will rise, by making households less willing to spend and by undermining corporate investment in new plant, equipment and hiring.
In the last few years, financial risk-taking has far outpaced economic risk-taking as investors have stretched far and wide for returns while companies have maintained high cash balances.
The result has been a notable differential between (high) asset prices and (more sluggish) fundamentals. If markets’ volatility continues and becomes more unruly, the consequences could extend beyond the convergence of portfolio risk exposure towards the lower level of economic risk taking. The latter could itself be contaminated, raising the nightmare risk of a self-feeding cycle of economic and financial instability.
Mohamed El-Erian is chief economic adviser to Allianz and chair of President Barack Obama’s Global Development Council