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Until the recent bout of financial-market turbulence, avariety of risky assets (including equities, government bonds, and commodities)had been rallying since last summer. But, while risk aversion and volatility were falling andasset prices were rising, economic growth remained sluggish throughout theworld. Now the global economy’s chickens may be coming home to roost.
Japan, struggling against twodecades of stagnation and deflation, had to resort to Abenomics to avoid aquintuple-dip recession. In the United Kingdom, the debate since last summerhas focused on the prospect of a triple-dip recession. Most of the eurozoneremains mired in a severe recession – now spreading from the periphery to partsof the core. Even in the United States, economic performance has remainedmediocre, with growth hovering around 1.5% for the last few quarters.
And now the darlingsof the world economy, emerging markets, have proved unable to reverse their ownslowdowns. According to the IMF, China’s annual GDP growth has slowedto 8%, from 10% in 2010; over the same period, India’s growth rate slowed from11.2% to 5.7%. Russia, Brazil, and South Africa are growing at around 3%, andother emerging markets are slowing as well.
This gap between WallStreet and Main Street (rising asset prices, despite worse-than-expectedeconomic performance) can be explained by three factors. First, the tail risks (low-probability,high-impact events) in the global economy – a eurozone breakup, the USgoing over its fiscal cliff, a hard economic landing for China, a war betweenIsrael and Iran over nuclear proliferation – are lower now than they were ayear ago.
Second, while growthhas been disappointing in both developed and emerging markets, financialmarkets remain hopeful that better economic data will emerge in the second halfof 2013 and 2014, especially in the US and Japan, with the UK and the eurozone bottoming out and mostemerging markets returning to form. Optimists repeat the refrain that “thisyear is different”: after a prolonged period of painful deleveraging, theglobal economy supposedly is on the cusp of stronger growth.
Third, in response toslower growth and lower inflation (owing partly to lower commodity prices), theworld’s major central banks pursued another round of unconventional monetaryeasing: lower policy rates, forward guidance, quantitative easing (QE), andcredit easing. Likewise, many emerging-market central banks reacted to slowergrowth and lower inflation by cutting policy rates as well.
This massive wave ofliquidity searching for yield fueled temporary asset-price reflation around theworld. But there were two risks to liquidity-driven asset reflation. First, ifgrowth did not recover and surprise on the upside (in which case high assetprices would be justified), eventually slow growth would dominate thelevitational effects of liquidity and force asset prices lower, in line withweaker economic fundamentals. Second, it was possible that some central banks –namely the Fed – could pull the plug (or hose) by exiting from QE and zeropolicy rates.
This brings us to therecent financial-market turbulence. It was already evident in the first andsecond quarters of this year that growth in China and other emerging marketswas slowing. This explains the underperformance of commodities andemerging-market equities even before the recent turmoil. But the Fed’s recentsignals of an early exit from QE – together with stronger evidence of China’sslowdown and Chinese, Japanese, and European central bankers’ failure toprovide the additional monetary easing that investors expected – dealtemerging markets an additional blow.
These countries havefound themselves on the receivingend not only of a correction in commodity prices and equities, but alsoof a brutal re-pricing of currencies and both local- and foreign-currencyfixed-income assets. Brazil and other countries that complained about “hotmoney” inflows and “currency wars,” have now suddenly gotten what they wishedfor: a likely early end of the Fed’s QE. The consequences – sharp capital-flowreversals that are now hitting all risky emerging-market assets – have not beenpretty.
Whether thecorrection in risky assets is temporary or the start of a bear market willdepend on several factors. One is whether the Fed will truly exit from QE asquickly as it signaled. There is a strong likelihood that weaker US growth andlower inflation will force it to slow the pace of its withdrawal of liquiditysupport.
Another variable ishow much easier monetary policies in other developed countries will become. TheBank of Japan, the European Central Bank, the Bank of England, and the SwissNational Bank are already easing policy as their economies’ growth lags that ofthe US. How much further they go may well be influenced in part by domesticconditions and in part by the extent to which weaker growth in Chinaexacerbates downside risksin Asian economies, commodity exporters, and the US and the eurozone. A furtherslowdown in China and other emerging economies is another risk to financialmarkets.
Then there is thequestion of how emerging-market policymakers respond to the turbulence: Willthey raise rates to stem inflationary depreciation and capital outflows, orwill they cut rates to boost flagging GDP growth, thus increasing the risk ofinflation and of a sudden capital-flow reversal?
Two final factorsinclude how soon the eurozone economy bottoms out (there have been some recent signs ofstabilization, but the monetary union’s chronic problems remain unresolved),and whether Middle East tensions and the threat of nuclear proliferation in theregion – and responses to that threat by the US and Israel – escalate or aresuccessfully contained.
A new period ofuncertainty and volatility has begun, and it seems likely to lead to choppyeconomies and choppy markets. Indeed, a broader de-risking cycle for financialmarkets could be at hand.
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