Financial markets are on tenterhooks after yet another wild week. Triple-digit intra-day moves in the Dow have become the norm rather than the exception. Conventional asset class correlations have broken down. Virtually every financial security has lost money. And liquidity dislocations are common.
Damage is not contained to financial markets. If these factors persist, they will undermine global economic fundamentals, thereby threatening adverse vicious cycles. So here are six factors that speak both to recent developments and what may happen next.
1. Markets are currently subject to a generalized assault on risk, whether in government bonds, commodities, corporate credit, currencies or equities. This price collapse reflects a yet-to-be-completed re-calibration of the underlying liquidity paradigm to better align portfolios’ risk postures with the ability either to re-position or tolerate the return to less artificial market conditions.
2. The proximate cause for this turbulence is the change in how markets perceive central banks’ willingness and ability to support artificial asset prices. Whether it is Fed Chairman Ben Bernanke’s remarks on the prospective tapering of unconventional purchases of securities (the hawkishness of which surprised many, including me) or concerns about the effectiveness of the Bank of Japan’s unusual activism, the outcome is the same. Markets now doubt their prior (considerable) faith in the power of central banks.
3. Considerable disconnects between asset prices and more sluggish fundamentals make this phase particularly volatile and disorderly. Remember, central banks saw artificially-elevated asset prices as a MEANS to meet their growth, job and inflation objectives. But herd behavior among market participants ended up pricing this as an END itself, inserting an even bigger wedge between valuations and fundamentals.
4. Judging from Chairman Bernanke’s remarks, the Fed is confident that improving fundamentals will overcome current turbulence and validate high prices. With others less sanguine about economic prospects, prices are now converging down to fundamentals rather than the other way around.
5. Mr. Bernanke being right on fundamentals (specifically, growth, jobs and inflation) speaks to more than the prospects for containing disorderly financial markets. It is also essential for placing a firmer footing under a global economy undermined by recession in Europe, a slowing China, some worrisome policy incoherence in other emerging markets, and disappointing global policy coordination.
6. Whether you diagnose the main problem as one of deficient aggregate demand, insufficient supply responsiveness, a damaging debt overhang or some combination of all three – and, as you know, economists are all over the map on this – all agree that western economies are yet to restore the engines needed for escape velocity. This critical problem is at the heart of reconciling many national and international inconsistencies. In some cases, an endogenous healing process could prove sufficient over time, especially if not countered by political dysfunction and policy mistakes. In other cases, however, and particularly in Europe, the problem is exhausted growth models.
I leave you to make your own judgment as to how these issues will play out from here. From my perspective, it appears that the West is nearing the end of the era where central banks are able to impose stability on a still-inherently-unstable set of economic and financial fundamentals.
Going forward, fundamentals (rather than financial engineering) will play a greater role in determining the level and correlation of asset prices. Should this indeed materialize, you should expect the current phase of generalized disruption to give way over time to greater differentiation.
That is the good news. The bad news is that specifying the exact time is inevitably difficult given inevitable market overshoots and the unpredictable dynamics of a market exhaustion process. It is also possible, though far from an overwhelming probability, that central banks may try new circuit breakers (notwithstanding the debilitating effect on their credibility and on resource misallocation).
When we get there, look for the following sequencing given a less strong outlook for global growth.
German and US government bonds would likely to be among the first to decouple from cascading liquidity disruptions, especially given now that they have violently re-priced. This would be followed by the gradual restoration of order to markets, like Mexico and in Asia, whose main vulnerability is due not to internal policy distortions/weak fundamentals but rather the excessive participation of “crossover investors” (or what some call “tourist dollars” – as in the first to flee on signs of turbulence). In the meantime, brace yourself for bouts of unusual market volatility.