The fear fac­tor in global mar­kets

Financial Mirror (Cyprus) - - FRONT PAGE -

The phe­nom­e­nal mar­ket volatil­ity of the past year owes much to gen­uine risks and un­cer­tain­ties about fac­tors such as Chi­nese growth, Euro­pean banks, and the oil glut. For the first two months of this year, many in­vestors were pan­icked that even the United States, the world’s most com­fort­ing growth story, was about to fall into re­ces­sion. In­deed, among the ex­perts who par­tic­i­pate in the monthly poll, 21% be­lieved a re­ces­sion was around the cor­ner.

I won’t deny that there are risks. A big enough hit to China’s growth or to Europe’s fi­nan­cial sys­tem could cer­tainly tip the global econ­omy from slow growth to re­ces­sion. An even more fright­en­ing thought is that by this time next year, the US pres­i­dency may have turned into a re­al­ity tele­vi­sion show.

Yet, from a macroe­co­nomic per­spec­tive, the fun­da­men­tals are just not that bad. Em­ploy­ment num­bers have been strong, con­sumer con­fi­dence is solid, and the oil sec­tor is just not large enough rel­a­tive to GDP for the price col­lapse to bring the US econ­omy to its knees. In fact, the most un­der-ap­pre­ci­ated driver of mar­ket sen­ti­ment right now is fear of an­other huge cri­sis.

There are some par­al­lels be­tween to­day’s un­ease and mar­ket sen­ti­ment in the decade af­ter World War II. In both cases, there was out­size de­mand for safe as­sets. (Of course, fi­nan­cial re­pres­sion also played a big role af­ter the war, with gov­ern­ments stuff­ing debt down pri­vate in­vestors’ throats below-mar­ket in­ter­est rates.)

Even a full decade af­ter World War II, when the fa­mous econ­o­mist John Ken­neth Gal­braith opined that the world might ex­pe­ri­ence an­other de­pres­sion, mar­kets went into a tizzy. Peo­ple still re­mem­bered how the US stock mar­ket had fallen 90% dur­ing the early years of the Great De­pres­sion. Back in the 1950s, it was not hard to i mag­ine that things might go wrong again. Af­ter all, the world had just nav­i­gated through a se­ries of catas­tro­phes, in­clud­ing two world wars, a global in­fluenza epi­demic, and of course the De­pres­sion it­self. Sixty years ago, the specter of atomic war also seemed real.

Peo­ple to­day need no re­mind­ing about how far and how fast equity mar­kets can fall. Af­ter the 2008 fi­nan­cial cri­sis, US stocks fell by more than 50%. Equity mar­kets in some other coun­tries fell sig­nif­i­cantly more: Ice­land’s, for ex­am­ple, plum­meted by over 90%. No won­der that once the re­cent mar­ket drop hit 20%, many peo­ple won­dered how much worse it could get – and whether fears of a new re­ces­sion could be­come a self­ful­fill­ing prophecy.

The idea is that in­vestors be­come so wor­ried about a re­ces­sion, and that stocks drop so far, that bear­ish sen­ti­ment feeds back into the real econ­omy through much lower spend­ing, bring­ing on the feared down­turn. They might be right, even if the mar­kets over­rate their own in­flu­ence on the real econ­omy.

On the other hand, the fact that the US has man­aged to move for­ward de­spite global head­winds sug­gests that do­mes­tic de­mand is


all too ro­bust. But this doesn’t seem to im­press mar­kets. Even those in­vestors who re­main cau­tiously op­ti­mistic about the US econ­omy worry that the US Fed­eral Re­serve will view growth as a rea­son to con­tinue rais­ing in­ter­est rates, cre­at­ing huge prob­lems for emerg­ing economies.

There are other ex­pla­na­tions for volatil­ity be­sides fear, of course. The sim­plest is that things re­ally are that bad. Maybe the in­di­vid­ual risks aren’t of the same or­der of mag­ni­tude as in the 1950s, but there are more of them, and mar­kets are start­ing from a much more in­flated po­si­tion.

More­over, fi­nan­cial glob­al­i­sa­tion has pro­foundly deep­ened in­ter­link­ages, mag­ni­fy­ing the trans­mis­sion of shocks. There are large pock­ets of fragility and weak­ness in world debt mar­kets, with cur­rent mon­e­tary eas­ing cov­er­ing up deep­rooted prob­lems be­neath the sur­face. Some have pointed to a lack of liq­uid­ity in lead­ing mar­kets as driv­ing the mas­sive price fluc­tu­a­tions; in a thin mar­ket, a small change in de­mand or sup­ply can some­times re­quire a big shift in prices to re­store equilibrium.

The most con­vinc­ing ex­pla­na­tion, though, is still that mar­kets are afraid that when ex­ter­nal risks do emerge, politi­cians and pol­i­cy­mak­ers will be in­ef­fec­tive in con­fronting them. Of all the weak­nesses re­vealed by the fi­nan­cial cri­sis, pol­icy paral­y­sis has been the most pro­found.

Some say that gov­ern­ments did not do enough to stoke de­mand. Al­though that is true, it is not the whole story. The big­gest prob­lem bur­den­ing the world to­day is most coun­tries’ ab­ject fail­ure to im­ple­ment struc­ture re­forms. With pro­duc­tiv­ity growth at least tem­po­rar­ily stuck in low gear, and global pop­u­la­tion in long-term de­cline, the sup­ply side, not lack of de­mand, is the real con­straint in ad­vanced economies.

In the long run, it is sup­ply fac­tors that de­ter­mine a coun­try’s growth. And if coun­tries can­not man­age deep struc­tural re­form af­ter a cri­sis, it is hard to see how it will hap­pen. Run­ning the govern­ment like a re­al­ity TV show, with one eye al­ways on the rat­ings, is not go­ing to do the job.

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