Why financial market shocks will be the new normal as central banks tighten their liquidity belts
Nicholas Spiro says the volatility on Wall Street in February and the turbulence in Italy, China and Turkey are not isolated events but the outcome of quantitative tightening
To be sure, benchmark interest rates remain near historic lows and there is little prospect of a severe credit crunch any time soon. Yet there has been a discernible shift in the financial landscape over the past year or so.
One of the clearest signs of this is the 60 basis point jump in the three-month London interbank offered rate (Libor), a benchmark for global borrowing costs, since January to its highest level since 2008. For the first time in a decade, cash is starting to become competitive, putting so-called “risk assets” under strain.
Watch: Wall Street tumbles in February
The rise in short-term interest rates stems from the withdrawal of stimulus by the leading central banks, led by the increasingly hawkish Federal Reserve. In a report published last month, JPMorgan noted that while the balance sheets of the main central banks will continue to expand this year, they will start to contract in 2019 for the first time since the financial crisis as the Fed’s bond portfolio shrinks at a faster pace and the European Central Bank, which ends its asset purchases in December, withdraws from the market.
Emerging markets are the most exposed because they stand to lose the most from a withdrawal of dollar funding. Yet rather than fretting about the scope for financial contagion from Turkey – a minnow compared with China’s economy, the most important gauge of sentiment towards developing nations – investors ought to focus on the bigger picture.
The MSCI Emerging Markets Index, a leading indicator of stocks in developing economies which entered bear market territory on Wednesday, was already down 18 per cent from its recent high in January at the end of June, long before Turkey’s currency crisis erupted. Moreover, commodity markets have been under pressure for months, with the price of copper, which also slipped into a bear market this week, falling in lockstep with the yuan.
If there is any contagion in markets, it is the growing number of shocks – both in advanced and developing economies – attributable to the effects of tightening liquidity.
The more frequent these shocks become, the less likely it is that investors will treat them as isolated events. In a year’s time – or perhaps sooner – the buzzword in markets will no longer be idiosyncratic but systemic.
Nicholas Spiro is a partner at Lauressa Advisory