Between inflation and cryptocurrencies, a stock market rout may send emerging economies over the edge
- As central banks raise rates to stay ahead of inflation, emerging economies with less robust growth and labour markets could scale back on fiscal support to cope with high prices and growing debt
- As crypto assets move more in sync with markets, they raise the risk of contagion across financial markets
The sudden plunge of the technology-heavy Nasdaq Composite index into correction territory (defined as a 10 per cent fall from a recent peak) was almost certainly a harbinger of worse to come, but more worrying are less obvious signs of systemic financial problems ahead.
There is trouble brewing in emerging markets, which suggests a market rout extending well beyond Wall Street and other advanced markets. Even worse, according to the International Monetary Fund, the fortunes of stock and cryptocurrency markets have now become linked in what could become a mutual spiral.
Yet still the idiocy persists in stock markets that this is some kind of manageable downward adjustment – another chance to buy the dip. This is nonsense. What seems to have escaped far too many stock investors and others is the fact that liquidity is draining rapidly from financial markets.
All boats rise and fall with the tide but the process might be more severe on the way down. Not only are the US Federal Reserve and other central banks draining liquidity by reversing asset purchases, it is also being sucked out by evaporating confidence.
It might not be necessary to shed tears for investors but the impact of a stock plunge on the wider economy from the current elevated heights could be disastrous. And the plunge will continue after the foolish buy-the-dip rally is over. Rising interest rates will see to that.
Fixed interest investment in bonds has become all the more attractive as real yields rise and this is likely to continue as central banks hike rates to stay ahead of inflation.
The apparent equanimity among investors that all will be well with stock prices, despite so many recent signs to the contrary – the idea that this will simply mark a rotation out of growth or tech stocks into so-called value stocks – is completely unjustified.
It marks a point where consumers, not just investors, begin to feel the impact. They see price rises as becoming entrenched and that feeds into future inflation expectations and into wage or pension demands. The upward spiral starts.
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Broad-based US wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally.
Meanwhile, US Federal Reserve officials speak with a forked tongue, depending on whether they are addressing politicians and the public or financial markets. A few days ago, Fed chair Jerome Powell warned during his Senate confirmation hearing that high inflation posed a severe threat to recovery in the US jobs market, while declaring the end of the era of pandemic stimulus.
That had equity investors running for cover. But a few days later, other Fed officials were suggesting that inflation is peaking. The warnings, followed by anodyne reassurances, were probably a vain attempt to let air out of the stock bubble slowly.
Other central banks will no doubt try similar tactics to ensure a controlled descent of stock markets.
Stock markets have become essential to boosting consumption and economic growth, but a disturbing recent report by the IMF revealed that many emerging market central banks have been playing the same game. They have taken a lead from the advanced economies and gone in for monetary easing. Now they are also facing elevated inflation and substantially higher public debt. However, in contrast to the United States, their economic recovery and labour markets are less robust.
Some emerging markets have already started to adjust monetary policy and are preparing to scale back fiscal support to address rising debt and inflation, according to the IMF.
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Some countries may need to rely on the global financial safety net. That may include using swap lines, regional financing arrangements, and multilateral resources, the IMF said. This hints at possible capital outflows and emerging market crises ahead and the IMF has begun to ready crisis- fighting measures in anticipation.
If this was not enough to cloud the outlook for financial markets, another recent report from the IMF does just that. Crypto assets, it noted, have matured from an obscure asset class with few users into an integral part of the digital asset revolution, raising financial stability concerns.
The market value of these novel assets rose to nearly US$3 trillion in November from US$620 billion in 2017, on soaring popularity among retail and institutional investors alike, despite high volatility. Since then, although the combined market capitalisation has retreated to about US$2 trillion, it still represents an almost fourfold increase since 2017.
Amid greater adoption, the correlation of crypto assets with traditional holdings like stocks has increased significantly, which limits their perceived risk diversification benefits and raises the risk of contagion across financial markets, the IMF suggested. One way or another, markets are entering a time of great uncertainty.
Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs.
