Investors stop buying the dip and start selling the rally
Markets belatedly coming to terms with the fact that central banks are running out of ammunition
The past fortnight has proved to be one of the most revealing periods in financial markets in recent years.
On January 20, global equities fell into bear market territory – defined as a price drop of at least 20 per cent from a prior high – because of the seemingly relentless slide in oil prices, mounting fears about China’s economic slowdown and waning confidence in central banks’ policies.
Then, on January 21, a confident-sounding Mario Draghi, the president of the European Central Bank (ECB), delighted investors by hinting at more monetary stimulus, triggering a rebound in equity and commodity markets, with oil prices pushing back above US$30 a barrel and US stocks enjoying their first weekly gain of 2016.
Yet no sooner had sentiment improved than stock markets began to wobble again, with Asian equities losing 1.6 per cent on Tuesday (dragged down by a 6.4 per cent decline in the Shanghai Composite Index) as oil prices began to fall again. However, US and European shares bounced back in late trade as oil prices recovered, with Brent crude rising more than 4 per cent to US$31.80 a barrel.
Two conclusions can be drawn from the recent price action of stock markets.
The most conspicuous one is that equity markets are now beholden to movements in oil prices. According to calculations by Reuters, the rolling 20-day correlation between oil prices and the benchmark US S&P 500 equity index has surged to nearly 95 per cent.
The second, and more important, one is that a shift appears to be taking place from the “buy the dip” strategy that has dominated equity trading since the global financial crisis to a “sell the rally” one.
If this is the case – and the turmoil in markets since the beginning of this year suggests it might well be – then the sharp declines in asset prices over the past four weeks could be a foretaste of things to come.
The strongest argument in support of a change in market psychology is that investors are losing confidence in the credibility and effectiveness of central banks’ policies.
SLJ Macro Partners, a prominent hedge fund, argued in a recent note that “central banks were never ‘omniscient’, and the equity market sell-off after years of aggressive monetary stimulus will expose this truth”.
What is clear is that the limits of monetary policy in underpinning investor sentiment during periods of market stress have been (or about to be) reached. Not only is the US Federal Reserve tightening policy, both the ECB and the Bank of Japan have, over the past few months, dashed investors’ hopes for more aggressive stimulus.
Markets are belatedly coming to terms with the fact that central banks are running out of ammunition – and that the ammunition they have left is either no longer effective and/or is proving increasingly difficult to fire.
The two central banks that are under mounting pressure to help stabilise markets by providing further stimulus – the ECB and Bank of Japan – are struggling to convince investors that their policies are working in the face of plunging oil prices, deflationary forces from China and weak domestic demand in both Europe and Japan.
Nearly three years of aggressive quantitative easing (QE) have left Japan with a core inflation rate (which excludes volatile food and energy prices) that is still less than half the Bank of Japan’s 2 per cent target.
Indeed, when the Bank of Japan announces its policy decision on Friday, it is not only likely to refrain from expanding its stimulus programme but is also likely to trim its inflation forecasts further and postpone the date when it expects to meet its elusive 2 per cent target.
In the euro zone, meanwhile, core inflation has remained near 1 per cent – less than half the ECB’s target – for the past several months, while the headline rate is barely above zero nearly a year after the ECB launched full-blown QE.
Still, while investors may be losing confidence in global monetary policies, central banks still have the power to shape sentiment significantly.
Expectations that the Fed, whose plans to raise rates another four times this year now look ill-conceived, will eventually be forced to halt its rate-hiking cycle are now a focal point of market anxiety.
An admission on the part of the US central bank that its tightening stance has been derailed risks undermining the Fed’s credibility.
This is one more reason why investors are likely to keep selling any rallies.
Nicholas Spiro is managing director of Spiro Sovereign Strategy