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A protester carries an American flag at Hong Kong Polytechnic University on November 20. Photo: AP
Opinion
Nicholas Spiro
Nicholas Spiro

Hong Kong’s protests complicate already fraught trade war tensions, and the markets know it. So why are they so stable?

  • Looking not only at major stock indices, but also gauges of consumer worry, there is little indication of global turmoil
  • This shows how powerful even glimmers of hope are; still, uncertainty over tariffs needs to end to keep the rally going

For most of 2017, the VIX Index, Wall Street’s “fear gauge” measuring the anticipated volatility in the benchmark S&P 500 index over the next 30 days, hovered around the 10-point level, just a tad above its all-time low. This was before the trade war erupted, and when the global economy was enjoying its broadest synchronised expansion since 2010.

On Wednesday, the index stood just below 13 points, having surpassed the 20 mark – its average level over the past 30 years – as recently as early October.

The collapse in volatility over the past month has occurred in the face of persistent tensions in US-China relations, a synchronised slowdown in the global economy and an outbreak of political and social unrest, with the crisis in Hong Kong complicating efforts to de-escalate the trade conflict.

Yet, in a sign of the extent to which equity markets are downplaying these risks, the S&P 500 has gone more than 30 sessions without suffering a back-to-back loss, the longest stretch since 2005, according to data from Bloomberg.

What is more, the index’s daily swings from peak to trough have averaged only 0.5 per cent this month, the lowest level of volatility since 1993, with the exception of 2017, the calmest year for the gauge since 1965, data from Bloomberg shows.

Stagnation in the EU has prompted the European Central Bank to resume its asset purchasing programme. Photo: Reuters

To be sure, the renewed calm in stock markets is being supported by further injections of liquidity by the world’s main central banks, particularly the European Central Bank, which has been forced to relaunch its asset purchase programme because of the collapse in growth in the euro zone.

The additional stimulus is fuelling a rally in debt markets underpinning lofty equity valuations, particularly in America. Indeed, bonds have rallied – the benchmark 10-year US Treasury yield currently stands less than 40 basis points above its record low – to such an extent that respondents to Bank of America Merrill Lynch’s November fund manager survey cited a bond bubble as the second most important “tail risk” in markets.

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The biggest threat by far, however, according to the poll, was the trade war. While the prospect of a “phase one” deal has been the main catalyst for the recent gains in asset prices, the rally belies serious misgivings among investors about any meaningful easing of trade tensions, especially in view of the increasing geo-politicisation of the Hong Kong protests following the US Senate’s Tuesday passage of the Hong Kong Human Rights and Democracy Act.

So the question remains: why are global stocks up 7 per cent since October 8 if markets are sceptical about the durability of any trade truce, to say nothing of the lack of progress in resolving the thornier, structural problems bedevilling US-China relations?

The simplest explanation is that markets’ overreaction to tentative signs that economic headwinds are easing has decreased investors’ sensitivity to the risks confronting the world economy. Excessive pessimism over the outlook for global growth set markets up for a bounce back the moment the data, however bleak, began to beat analysts’ expectations.

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Put simply, glimmers of hope have had a disproportionate impact on sentiment. If there was less uncertainty surrounding the main sources of the recent decline in volatility – trade talks and global growth – stock markets could continue to go higher.

Yet, the fragility of the improvement in sentiment shows how reliant asset prices are on convincing evidence that trade tensions are easing and growth is improving. As the Bank of America Merrill Lynch survey rightly noted, the “easy part of [the] rally is over, [the] tougher part [is just] beginning”.

A television screen on the floor of the New York Stock Exchange shows President Donald Trump's speech to the Economic Club of New York on November 12. Photo: AP

Indeed, the rally may have already run its course. On Wednesday, the S&P 500 suffered its sharpest decline in six weeks in response to the Hong Kong-induced tensions in trade talks.

Even if the mood music improves again, the bar for further gains in equities is getting higher by the day. As I have argued previously, the fear of missing out is a brittle foundation for a sustainable rally.

Markets lifted by US-China trade, Brexit breakthroughs but deep risks lurk

At the very least, the debilitating uncertainty surrounding tariffs needs to end, while signs that the global slowdown has bottomed out need to be validated in the coming months.

The contradictory signals that have pervaded markets this year have been enough to avert a sharp and disorderly sell-off. Yet, the longer the confusion about the prospects for the global economy persists, the greater the risk that volatility returns with a vengeance.

Nicholas Spiro is a partner at Lauressa Advisory

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