Volatility the new watchword for financial markets

The main reason behind the recent increase in volatility is the China factor

PUBLISHED : Thursday, 07 January, 2016, 8:22am
UPDATED : Thursday, 07 January, 2016, 12:02pm

In 2015, there was no shortage of risks for financial investors to fret about.

There was the year-long speculation about the precise timing of – and the likely fallout from – the first rise in US interest rates in nearly a decade. In June, the sudden bursting of China’s equity market bubble heightened fears about the mainland’s economy and policy regime. Last but not least, there was the dramatic decline in commodity prices (mainly because of China’s slowing economy) that pulled the rug out from under emerging market (EM) assets and caused severe tremors in corporate debt markets.

As 2016 gets under way, all three of these vulnerabilities continue to weigh on sentiment and, together with the ever more frequent bouts of geopolitical risk (the latest being the severe escalation in tensions between Saudi Arabia and Iran), suggest this year’s trading environment is likely to prove just as perilous as last year’s – if not more.

While the world’s main central banks, particularly the US Federal Reserve, managed to suppress volatility levels in markets through ultra-accommodative monetary policies – the VIX equity volatility index, Wall Street’s so-called “fear gauge”, stood below its long-term average of 20 for nearly the entirety of the period from June 2012 to October 2014 – markets have become much more jittery since last summer.

Confidence in the credibility of Chinese policymaking is being undermined

Volatility is the new watchword for equity, bond and currency markets.

Part of the reason for this is that central banks themselves have become sources of volatility.

The dithering on the part of the Fed about when to raise rates, the imprudent communication policy of the European Central Bank (ECB) which raised expectations about further monetary stimulus only to disappoint investors at its policy meeting last month and, most troublingly, the inability of central banks to fix the underlying fiscal and structural problems plaguing many advanced and emerging economies – all these factors are now contributing to the uncertainty and fear in markets.

Another reason why volatility levels have risen is because central banks have parted ways, with the Fed tightening policy and the ECB and the Bank of Japan still undertaking aggressive quantitative easing (QE).

This policy divergence has had a profound impact on capital flows and foreign exchange markets, with the dollar index – a gauge of the greenback’s performance against a basket of its peers – surging 24 per cent since mid-July 2014. This has been a major contributor to the weakness of EM currencies, with the Brazilian real and the Malaysian ringgit plummeting 80 per cent and 37 per cent respectively against the US dollar during this period.

Yet the main reason behind the recent increase in volatility is the China factor.

Investors have become much more sensitive to developments in China following the start of a series of frantic attempts on the part of Beijing to shore up the country’s stock market and the mishandled devaluation of the yuan last August.

This heightened sensitivity was thrown into sharp relief on Monday, when a 7 per cent plunge in the mainland’s CSI 300 Index shut down the Shanghai and Shenzhen markets and triggered steep declines in global equity markets, with the benchmark US S&P 500 index falling 1.5 per cent and EM stocks tumbling 3.3 per cent.

While stock markets stabilised somewhat on Tuesday following further interventions by Beijing to prop up the mainland’s equity and currency markets, they were shut down again on Thursday morning following another 7 per cent plunge in the CSI 300 Index. Confidence in the credibility of Chinese policymaking is being undermined just as the severity of the economic downturn and the acute difficulties in undertaking reforms are becoming ever more apparent.

Indeed the yuan itself is becoming a focal point for market anxiety.

On Wednesday, the yuan fell to a five-year low against the US dollar amid confusing signals from Beijing about the mainland’s exchange rate policy. Pressure on the central government to devalue the yuan further in order to help shore up the economy is fuelling fears of an intensification of “currency wars”, causing the Bloomberg JP Morgan Asia Dollar Index – a gauge of the performance of the region’s main currencies with the exception of the yen – to slide to its lowest level since April 2009.

The danger for markets right now is that all these risks – fears about China, the rout in the commodities complex, geopolitical ructions and the rise in US interest rates – start to feed on each other, creating a vicious circle in which sentiment deteriorates further.

Still, the Vix index currently stands just below 20, suggesting that the jury remains out as to whether deteriorating sentiment turns into full-blown panic.

Further volatility, however, is a foregone conclusion.

Nicholas Spiro is managing director of Spiro Sovereign Strategy