A bru­tal week in mar­kets, but what comes next?

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

In­vestors around the world will be look­ing to next week with some anx­i­ety as they lick their wounds. A bru­tal week of losses was ac­cen­tu­ated by an un­pleas­ant close for the U.S. stock mar­kets that saw the Dow Jones In­dus­trial Av­er­age plunge more than 500 points (3 per­cent) for the day and tak­ing it into cor­rec­tion ter­ri­tory, or down more than 10 per­cent from its last high. The losses for the week were ac­com­pa­nied by even larger ones else­where, in­clud­ing emerg­ing-mar­ket cur­ren­cies and oil. In as­sess­ing what lies ahead, in­vestors would be well ad­vised to con­sider six ma­jor fac­tors that have brought mar­kets to this un­com­fort­able point.

Un­like some pre­vi­ous episodes -- in­clud­ing the 2008 global fi­nan­cial cri­sis and the 2013 "ta­per tantrum," as well as those as­so­ci­ated with euro-zone con­cerns -- the cat­a­lyst for this mar­ket re­treat came from out­side the de­vel­oped world. It largely re­flected con­cerns about slow­ing growth in emerg­ing economies (China in par­tic­u­lar, but also Brazil, Rus­sia and Tur­key), com­pound­ing the en­trenched eco­nomic slug­gish­ness in Europe and Ja­pan.

Global growth con­cerns were in­ten­si­fied by the strug­gles pol­icy mak­ers in emerg­ing mar­kets are hav­ing in sta­bi­liz­ing their do­mes­tic fi­nances and lim­it­ing fur­ther dam­age to their economies. Again, China is un­der the spotlight given ques­tions about whether gov­ern­ment in­ter­ven­tions have sta­bi­lized its do­mes­tic stock mar­ket.

The im­pact of lower global growth was par­tic­u­larly painful for other mar­kets that al­ready were un­der pres­sure from de­vel­op­ments on the sup­ply side. As such, the plunge in oil prices high­lighted the ex­tent to which the mar­ket's new de facto swing pro­ducer -- the U.S. -- doesn't play the same role that the Or­ga­ni­za­tion of Petroleum Ex­port­ing Coun­tries did at the height of its power.

Ex­ports from emerg­ing economies, par­tic­u­larly raw ma­te­ri­als pro­duc­ers, are most at risk from the com­bi­na­tion of slow­ing growth and lower world­wide com­mod­ity prices. Ac­cord­ingly, the mar­ket car­nage was great­est in emerg­ing-mar­ket cur­ren­cies, push­ing losses to lev­els be­yond what was ex­pe­ri­enced dur­ing the global fi­nan­cial cri­sis in 2008. And these mar­kets are tech­ni­cally the most prone to over­shoot, with sig­nif­i­cant and ad­verse spillover ef­fects on other mar­kets.

Be­cause some port­fo­lios are de­signed to un­wind dur­ing tur­moil and height­ened volatil­ity, fi­nan­cial mar­kets slipped into the desta­bi­liz­ing grip of con­ta­gion -- with the risk of over­shoot­ing. The VIX, com­monly re­ferred to as the fear in­dex, soared. Richly val­ued stocks, par­tic­u­larly in the tech in­dus­try, were bat­tered. This in­evitably un­der­mines the buy-on-dips men­tal­ity, lead­ing in­vestors with dry in­vest­ing pow­der to wait on the side­lines for now.

There is less con­fi­dence that cen­tral banks -- re­peat­edly the mar­kets' best friends -- can act as im­me­di­ate and ef­fec­tive sta­bi­liz­ers. More­over, the Fed­eral Re­serve's min­utes re­leased on Wed­nes­day -- in which the cen­tral bank had no choice but to seem wishy-washy --high­lights the pol­icy chal­lenges in a world that has come to over-rely on cen­tral banks. In­deed, the cult of cen­tral banks has driven a wedge be­tween as­set prices and eco­nomic fun­da­men­tals.

Yes, the Peo­ple's Bank of China could loosen mon­e­tary pol­icy; and, yes, the Fed could hold off hik­ing rates in Septem­ber. But the im­pact on global growth would likely be lim­ited un­less these steps are ac­com­pa­nied by a more com­pre­hen­sive pol­icy re­sponse. Oth­er­wise, prices need to fall a lot more be­fore wary in­vestors get off the side­lines.

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