The three fears sink­ing global mar­kets

Financial Mirror (Cyprus) - - FRONT PAGE -

Jan­uary is usu­ally ex­pected to be a good month for stock mar­kets, with new money gush­ing into in­vest­ment funds, while taxre­lated sell­ing abates at the end of the year. Al­though the data on in­vest­ment re­turns in the United States ac­tu­ally show that Jan­uary prof­its have his­tor­i­cally been on only slightly bet­ter than the monthly norm, the wide­spread be­lief in a bullish “Jan­uary ef­fect” has made the weak­ness of stock mar­kets around the world this year all the more shock­ing.

But the pes­simists have a point, even if they some­times over­state the Jan­uary magic. Ac­cord­ing to statis­ti­cians at Reuters, this year started with Wall Street’s big­gest first­week fall in over a cen­tury, and the 8% monthly de­cline in the MSCI world in­dex made Jan­uary’s per­for­mance worse than 96% of the months on record. So, just how wor­ried about the world econ­omy should we be? Three fears now seem to be in­flu­enc­ing mar­ket psy­chol­ogy: China, oil and the fear of a US or global re­ces­sion.

China is surely a big enough prob­lem to throw the world econ­omy and equity mar­kets off the rails for the rest of this decade. We saw this in the first four days of the year, when the sud­den fall in the Chi­nese stock mar­ket trig­gered Jan­uary’s global fi­nan­cial may­hem. But the Chi­nese stock mar­ket is of lit­tle con­se­quence for the rest of the world. The real fear is that the Chi­nese au­thor­i­ties will ei­ther act ag­gres­sively to de­value the ren­minbi or, more con­trol of it through mis­man­age­ment, re­sult­ing in cap­i­tal flight.

Such a sce­nario seemed quite plau­si­ble for a few weeks last sum­mer, and it reemerged as a threat in the first two weeks of this year. By the end of Jan­uary, how­ever, mar­ket sen­ti­ment had moved back in fa­vor of sta­bil­ity in China. This calm could be dis­rupted again if China’s for­eign-ex­change re­serves show an­other huge monthly loss, and the au­thor­i­ties’ ef­forts to man­age an or­derly eco­nomic slow­down will re­main the big­gest source of le­git­i­mate con­cern for fi­nan­cial mar­kets for many years ahead. But, judg­ing by mar­ket be­hav­ior in the se­cond half of Jan­uary, the fear about China has sub­sided, at least for now.

That can­not be said about the mar­ket’s se­cond great worry: col­laps­ing oil prices. From the mo­ment in­vestors stopped pan­ick­ing about China, in the se­cond week of Jan­uary, stock mar­kets around the world started fall­ing (and oc­ca­sion­ally re­bound­ing) in lock­step with the price of oil. Un­like the rea­son­able con­cern about China, mar­ket sen­ti­ment seems sim­ply to have got­ten the re­la­tion­ship be­tween oil and the world econ­omy wrong. In any­thing but the very short term, the cor­re­la­tion be­tween oil prices and stock mar­kets should be neg­a­tive, not pos­i­tive – and will al­most cer­tainly turn out that way in the years ahead.

When oil prices plunge by 10% daily, this is ob­vi­ously dis­rup­tive in the short term: credit spreads in re­sources and re­lated sec­tors ex­plode, and lever­aged in­vestors are forced into as­set fire sales to meet mar­gin calls. For­tu­nately, mar­ket panic now seems to be sub­sid­ing, as oil prices reach the lower part of the $25-50 trad­ing range that al­ways seemed ap­pro­pri­ate in to­day’s political and likely, lose ac­ci­den­tal dev­as­tat­ing eco­nomic con­di­tions. Now that oil prices are sta­bi­liz­ing at a rea­son­able long-term level, the world econ­omy and non-com­mod­ity busi­nesses should ben­e­fit. Low oil prices in­crease real in­comes, stim­u­late spend­ing on non-re­source goods and ser­vices, and boost prof­its for en­ergy-us­ing busi­nesses.

Yet, de­spite th­ese ob­vi­ous ben­e­fits, most in­vestors now seem to be­lieve that fall­ing oil prices point to a col­lapse in eco­nomic ac­tiv­ity, which brings us to the third fear haunt­ing fi­nan­cial mar­kets this win­ter: a re­ces­sion in the global econ­omy or the US.

Past ex­pe­ri­ence sug­gests that oil prices are not a use­ful lead­ing in­di­ca­tor of eco­nomic ac­tiv­ity. In fact, if oil-price move­ments have any rel­e­vance at all in eco­nomic fore­cast­ing, it is as a con­trary in­di­ca­tor. Ev­ery global re­ces­sion since 1970 has been pre­ceded by a big in­crease in oil prices, while al­most ev­ery de­cline greater than 30% has been fol­lowed by ac­cel­er­at­ing growth and higher equity prices. The wide­spread view that plung­ing oil prices au­gur re­ces­sion is a clear case of the be­lief that this time is dif­fer­ent – a be­lief that typ­i­cally takes hold in fi­nan­cial mar­kets at the peaks and troughs of boom-bust cy­cles.

Fi­nally, what about the fall­ing stock mar­ket it­self as an in­di­ca­tor of re­ces­sion risks? One could quote the great econ­o­mist Paul Sa­muel­son, who fa­mously quipped in the 1960s that the stock mar­ket had “pre­dicted nine of the last five re­ces­sions.” There is, how­ever, a less re­as­sur­ing an­swer. While mar­kets are of­ten wrong in pre­dict­ing eco­nomic events, fi­nan­cial ex­pec­ta­tions can some­times in­flu­ence those events. As a re­sult, re­al­ity can some­times be forced to con­verge to­wards mar­ket ex­pec­ta­tions, not vice versa.

This process, known as “re­flex­iv­ity,” is a pow­er­ful force in fi­nan­cial mar­kets, es­pe­cially dur­ing pe­ri­ods of in­sta­bil­ity or cri­sis. To the ex­tent that re­flex­iv­ity works through con­sumer and busi­ness con­fi­dence, it should not be a prob­lem now, be­cause the oil-price col­lapse is a pow­er­ful an­ti­dote to the stock-mar­ket de­cline. Con­sumers are gain­ing more from cheap oil than they are los­ing from fall­ing stock prices, so the net ef­fect of re­cent fi­nan­cial tur­moil on con­sump­tion should be pos­i­tive – and stronger con­sump­tion should feed through to busi­ness rev­enues.

A greater worry is the work­ings of re­flex­iv­ity within the fi­nan­cial sys­tem it­self. Bank­rupt­cies among small en­ergy-sec­tor com­pa­nies, which are of lim­ited eco­nomic im­por­tance them­selves, are cre­at­ing pres­sures in global bank­ing and re­duc­ing the avail­abil­ity of credit to healthy busi­nesses and house­holds that would oth­er­wise be ben­e­fi­cia­ries of cheaper oil. Fears of a Chi­nese de­val­u­a­tion that has not hap­pened (and prob­a­bly never will) are hav­ing the same chill­ing ef­fect on credit in emerg­ing mar­kets. Mean­while, bank­ing reg­u­la­tors are con­tin­u­ing to tighten lend­ing stan­dards, even though eco­nomic con­di­tions sug­gest they should be eas­ing up.

In short, noth­ing about the con­di­tion of the world econ­omy sug­gests that a ma­jor slow­down or re­ces­sion is in­evitable or even likely. But a lethal com­bi­na­tion of self­ful­fill­ing ex­pec­ta­tions and pol­icy er­rors could cause eco­nomic re­al­ity to bend to the dis­mal mood pre­vail­ing in fi­nan­cial mar­kets.

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