Reliance on central banks risks more market volatility

An investor walks past a screen showing stock market movements at a stocks firm in Hangzhou, eastern China's Zhejiang province on February 29, 2016. Chinese stocks fell on February 29 on worries over the weaker yuan and disappointment at the vagueness of a weekend pledge by G20 countries to tackle slowing global growth. AFP PHOTO CHINA OUT / AFP / STR (Photo credit should read STR/AFP/Getty Images)©AFP
There is more at stake for markets than enhancing the value of stocks as the global economy fails to achieve lift-off, and governments struggle in transitioning away from over dependence on central Banks.
The availability of liquidity to support the well-functioning of markets, together with the appropriate balance between regulation and efficiency, are also in play. All of which renders the outlook for markets an important component of the overall prospects for economic growth, jobs, inequality and financial stability; and this at a time when popular disillusionment has fuelled the emergence of anti-establishment movements on both side of the Atlantic.

In their meeting in China 10 days ago, G20 officials rightly pointed to mounting risks facing a weakening global economy that, in certain areas, is still burdened with excessive debt. In assessing their collective policy requirements, they emphasised a need to pivot away from prolonged and excessive dependence on unconventional monetary policy and towards a comprehensive deployment of “monetary, fiscal and structural” measures.
Yet, as critical as these recognitions are the G20 did not follow through with strengthened policy formulation and implementation. The meeting’s policy commitments were a rehash of what has been said before; and these have been largely unimplemented, as political polarisation and dysfunction in key countries act as constraints. Moreover, when China acted just hours after the G20 meeting ended to stimulate its slowing economy it again resorted to monetary policy, injecting an extra $106bn of liquidity.
Continued overreliance on monetary policy is likely to deliver even less in sustainable growth while increasing the threat of damaging collateral damage and unintended consequences. As such, it also puts at risk asset prices that, having already been bolstered by significant injections of public and private sector liquidity, are decoupled from fundamentals. Improved economic and corporate fundamentals are needed to validate the existing prices of risk assets, most importantly stocks, and to take them higher.

A macroeconomic pivot towards a more comprehensive policy response is also required to underpin the well-functioning of markets. On more than a couple of occasions in the past few years, including the May 2013 “taper tantrum” and the more recent concerns with China’s economic wellbeing, the availability of market liquidity has proven insufficient to allow orderly portfolio repositioning. And this has accentuated a more general increase in realised volatility in many market segments.
These days, even small changes to market paradigms cause outsized price moves, contagion, and unsettling correlations among asset classes. The phenomenon is accentuated by today’s lack of “patient capital”, be it investments from sovereign wealth funds or long-term institutional investors in both Europe and the US that were previously able and willing to act counter-cyclically. In such circumstances, broker-dealers are even less inclined to step in, fearing a backlash both from regulators and their shareholders with shorter-term horizons.

The threat of such market instability also assumes another regulatory dimension now that important components of risk-taking have morphed and migrated outside the banking sector.

As such, it could well encourage additional regulatory interest in non-banks and much greater disclosure requirements, be they asset managers, hedge funds or the rapidly growing “fintech” sector.

All this sets up the possibility of a disconcerting cycle of spillovers and spillbacks. Should this materialise, global economic weakness and too-partial a policy response would place renewed pressured on asset prices. Combined with the possibility of market malfunctions and increasing regulation, this would spill back on to economic activity via less robust consumption, more difficult financial intermediation and muted corporate investments.

Without better economic and corporate fundamentals validating existing market prices and providing them with a stronger anchor, the global economy will find itself at much greater risk of contamination from more volatile and occasionally malfunctioning financial markets. The result would be the increased threat of an even deeper downturn in growth that would fuel inequality, add to popular dissatisfaction with the political process and render a sustainable recovery even harder to deliver.

Mohamed El-Erian is chief economic adviser to Allianz and author of the book ‘The Only Game in Town’

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