The markets’ bumpy ride need not become a crash

Financial markets began 2014 in an ebullient mood. Omens of economic recovery in the developed world buoyed investors across the globe. Troubles in emerging markets, it was thought, would amount only to a handful of little local difficulties.

It did not last.

In developed markets, the past three weeks have seen the steepest falls in equity prices since mid-2013, when fears that the US Federal Reserve would begin phasing out its massive bond-buying programme caused interest rates to surge. This time, however, there has been no rise in short-term interest rates in the US or Europe, and bond yields have fallen slightly. There has been no change then in the market’s reading of the Fed or the European Central Bank’s policy stance.

Instead, traders have been rattled by the indications that global economic demand is weaker than thought. Inflation now stands at about a paltry 1 per cent in the US and Europe, and there has been a string of disappointing data on US economic activity.

In previous years, this combination of events might already have had the Fed signalling a willingness to use monetary policy to stimulate the economy. But so far in 2014 the silence has been deafening.

Investors have long believed that under Alan Greenspan and then Ben Bernanke, the Fed deliberately shielded the stock market from losses by using monetary policy to lift share prices whenever they suffered steep falls. Now investors are debating whether Janet Yellen, the incoming chairwoman, will do the same. Many are nervous. Ms Yellen has been silent on all the main issues for almost a year. Stanley Fischer, the likely vice-chairman, is thought to be sceptical about some of the most dovish aspects of recent Fed orthodoxy.

None of this would matter if the US economy had maintained the healthy rates of growth seen in late 2013. But growth seems to have dipped to about 2 per cent in the current quarter, from 3.5 per cent in the second half of last year. Markets had been cheered by a recent outbreak of sanity in Congress, which has slowed the pace of spending cuts compared to last year and now seems less likely to take America back to the brink of technical default. But now the fear is that this will not be enough. The economy might return to earth with a thud, as it did after a short spurt of growth in 2009-10.

The Fed plans to taper its asset purchases only very gradually. Yields on long-term bonds may be affected by as little as 1 per cent. If the US economy proved unable to withstand even this featherweight touch, market optimists would lose their nerve. The stock market has risen a very long way – shares are currently selling for fairly high multiples of company profits, by historical standards. A bear market could ensue.

Yet these fears seem overblown. The January weakness in US employment data, and in the ISM manufacturing survey, shocked the markets, but other statistics have painted a brighter picture. The slowdown may turn out to be a blip, caused by a one-off pause while companies run down excess inventories, or the effects of extraordinary weather. If this view proves correct – and I think it will – the recovery will strengthen later in the year.

This sanguine assessment does not, however, apply to the emerging markets, where a storm is brewing.

Since the Fed began its quantitative easing, investors who could no longer earn their keep buying US government debt have ventured further afield. This has resulted in a huge influx of capital into countries such as Turkey and Brazil. But the ensuing credit bubbles were not sufficiently controlled by monetary authorities, and now that policy is being tightened in the west, they threaten to burst. Central banks in emerging markets have been pleading for help. But these calls have been politely dismissed by both the Fed and ECB, whose job is to look after their economy at home.

Now China has decided to reverse its own huge monetary stimulus. Both of the world’s major economic powers are therefore pulling in the wrong direction for most emerging nations. They have not been helped by the collapse in the yen, which in effect cuts the price of Japanese products, or the euro area’s growing trade surplus. They have little option but to let their currencies slide, with rising interest rates and slowing growth rates looking inevitable.

In many emerging markets, monetary conditions are tightening sharply – just what these economies do not need. In the wake of a boom fuelled by cheap credit, the spectre of widespread insolvency looms.

All eyes are now on China. Few, if any, major economies have emerged intact from a credit bubble as intensive as the one in China’s shadow banking sector today. But no country has had $3.5tn of liquid reserves to fall back on either.

China’s decision in December to bail out an investment product distributed by its largest bank shows that for now the authorities would rather absorb the losses of the private sector than sow panic among investors. But before this is over there will be failures in financial institutions, just as there were in 1998 when Premier Zhu Rongji allowed the collapse of Gitic to serve as a lesson to others.

Investors are asking whether the markets can survive tapering by the Fed. The harder question is whether they can survive a monetary tightening by the People’s Bank of China. Many are betting on a bumpy landing, but one that does not involve a serious recession. They may be right, but China is where the unknown unknowns in the global economy currently lurk.


Gavyn Davies



FT