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
One of the buzzwords in financial markets this year has been “idiosyncratic”. A series of shocks that began in early February with a sudden eruption of volatility in US stock markets and have since put Italy, China and now Turkey under strain have been treated by international investors as disparate sell-offs, each with their own causes and catalysts.
At first glance, this appears to be the case. The turbulence in US equity markets – which stemmed mainly from an abrupt unwinding of the so-called “short volatility” trade in which investors bet heavily on continued calm in stock markets – had little to do with the escalation in political risk in Italy in May due to fears about the new populist government’s commitment to the rules underpinning the euro.
Even within emerging markets, the reasons behind the four-month-long period of turmoil differ, depending on the country. While the sharp falls in China’s currency and equity markets have been driven mainly by fears about the impact of the trade war on the country’s slowing economy, this month’s dramatic decline in Turkey’s currency is attributable to fears that the country will not be able to meet its large external financing requirements.
Yet, on closer inspection, a common thread runs through this year’s market blow-ups: the steady tightening of financial conditions which is making investors more sensitive to the plethora of vulnerabilities in both advanced and developing economies.
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.
The cumulative effect of all this is a liquidity squeeze which is reducing the availability of US dollars for the global economy, making a lot of riskier investments, from emerging market currencies to high-yield corporate bonds, look less attractive. The impact is magnified by this year’s surge in the dollar index – a gauge of the greenback’s performance against a basket of other currencies – which this week reached its highest level in 14 months.
While markets only focus on one shock at a time, this year’s succession of sell-offs, far from being isolated events, form a worrying pattern. Not only do they represent the first major tremors in the shift from the era of quantitative easing to quantitative tightening, they reveal the extent to which this regime change in markets is likely to depress asset prices further as more liquidity is drained from the financial system.
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