Four reasons why financial contagion has gone away – at least for now
There is ‘plenty of scope for the kind of financial shock which could lead to the return of systemic risk’
In early morning trading on Monday, the Turkish lira, one of the most actively traded emerging-market currencies, plunged more than 6 per cent versus the dollar after the decision by the US to suspend the processing of the bulk of new visas in Turkey, a member of Nato and a crucial strategic ally for the West. While the lira clawed back most of its losses, Turkish assets suffered their worst day in nearly a year, according to data from Bloomberg.
Yet as sentiment towards Turkey deteriorated sharply, the financial markets of other major developing economies remained calm. The MSCI Emerging Market Index, the main equity gauge for developing nations, barely budged on Monday and even rose more than 1 per cent on Tuesday. Meanwhile spreads, or the risk premium, on dollar-denominated emerging market government bonds remain close to their lowest levels since 2010, according to JPMorgan.
In another sign that financial turmoil in one major economy is having little effect on other countries’ markets, a sell-off in the equity and bond markets of Spain, triggered by a controversial vote for independence in Catalonia (a region whose economy accounts for a fifth of Spain’s GDP) on October 1, had a muted impact on European asset prices. While Spanish stocks fell 4 per cent in the three days following the referendum, the equity markets of the entire euro zone were flat. Just as tellingly, while exchange-traded funds tracking Spanish shares suffered US$250m in outflows last week, other major European equity markets saw money coming in.
Why have significant declines in asset prices in two leading developing and developed economies failed to spill over into other countries’ markets, as was the case during the acute phase of the euro zone crisis in 2011-12 and the so-called taper tantrum in 2013 following the decision by the Federal Reserve to begin scaling back its asset purchases?
The simplest explanation lies in the exceptionally low levels of volatility in global markets stemming from the ultra-loose monetary policies on the part of the world’s leading central banks.
Despite two interest rate increases by the Fed this year – and, according to futures markets, a 90 per cent probability of another one in December – financial conditions have eased significantly.
This has been helped by what analysts at Bernstein call the “the great correlation collapse” – different markets and asset prices are no longer moving in lockstep with each other, resulting in a breakdown in correlations and a rise in country- and sector-specific trading strategies.
Secondly, global investors are desperately seeking to generate higher returns in response to persistently low yields on government debt in advanced economies – particularly in Japan and Europe which account for the overwhelming bulk of the US$10.2 trillion international stock of negative-yielding sovereign debt. Even Turkey’s local-currency bond market managed to attract almost US$1 billion of inflows last month because of the extremely high yields on offer relative to developed markets.
Thirdly, investors are in a bullish mood, buoyed by a pickup in global growth, solid corporate earnings and, in emerging markets, cheaper equity valuations and improved economic fundamentals.
Fourth, and perhaps most importantly, in order for financial contagion to rear its ugly head again, there needs to be a return of “systemic risk”, defined by regulators as “a risk of disruption to financial services caused by an impairment of all or parts of the financial system [with] serious negative consequences for the real economy.”
Not only are such vulnerabilities conspicuously absent in markets right now, but most investment strategists see little likelihood of another major financial crisis any time soon.
So is contagion a thing of the past?
There is no question that it would take an almighty financial shock to trigger a sufficiently sharp and sustained decline in asset prices for contagion to erupt again.
It is not going to be Turkish visas or Catalonia’s push for independence that causes a broad-based sell-off.
Still, the dangerous combination of a removal of years of monetary stimulus and overstretched valuations in bond and equity markets creates plenty of scope for the kind of financial shock which could lead to the return of systemic risk.
On Wednesday, the International Monetary Fund warned that an excessive build-up of private debt, “financial excesses” and huge difficulties in normalising monetary policy could be sowing the seeds of the next global financial crisis.
The IMF also noted that subdued volatility in markets was breeding complacency among investors.
Financial contagion may have disappeared for now, but it could resurface much sooner than many think.
Nicholas Spiro is a partner at Lauressa Advisory