The Good, the Bad, and the Ugly in the Global Market Turmoil

Uncertainty is stalking the markets again, and it’s the worst kind. The recent rout in China and emerging markets has led to the kind of unmeasurable risk — call it black swans, unknown unknowns, or long tail events — that leads to shocks in volatility and investors’ confidence, ultimately causing credit to dry up and markets to stop functioning normally. Now it gets ugly.

It’s hard to tell how long-lasting, disorderly, and consequential the current bout of market volatility will prove to be for the global economy. This time, investors can’t look to the major central banks for solutions to the latest triggers of financial instability. There is little that the Federal Reserve, or any other major central bank, can do about China’s economic rebalancing, about political risk and stalled reforms in emerging markets, or about excess capacity in the global energy industry. The only certainty is that a fresh impetus in the policy debate about how to generate more global demand, as opposed to inflating bubbly market valuations, is a healthy development for the future.

The fallout has been deep and widespread. The Dow Jones Industrial Average suffered the worst 3-day point decline in its history, seeing a peak-to-trough collapse of 1620 points. While the market has rebounded since — the Dow recovered 619 points on Aug. 26 — that is still a drop in a bucket and collateral damage has been done. The Standard and Poor’s 500 Index lost nearly $900 billion in market capitalization in the first two sessions of this week. This is more than the entire stock of Treasury debt ($790 billion) purchased by the Fed under its third quantitative easing program between September 2012 and October 2014. The rout in global equities has wiped off nearly $7 trillion from the value of global corporate capital since China unexpectedly devalued the yuan on Aug. 11. This is nearly 9 percent of global GDP. It has also triggered a broad-based sell-off across currencies and commodities, from the Malaysian ringgit (down 8 percent against the dollar, at a 19-year low) to the dollar (down 3 percent against the euro) and oil (down 14 percent) to gold (down 3.5 percent this week).

Though the turmoil began with investors’ worries that leaders in Beijing hadn’t got a handle on China’s economic problems, the ripple effects have raised questions over the prospects for the United States’ economy. Cheaper Chinese exports and weaker commodity prices, which tamp down inflation, have also called into question the ability of the Federal Reserve to raise interest rates this year. Where the discussion a month ago was about when the Fed might raise rates, talk of a fourth quantitative easing program has edged in. The probability of a September Fed rate rise is down to 24 percent, from 54 percent at the start of the month, and a move in 2015 is now seen as still possible but unlikely (a less than 50 percent chance), according to U,S, rate futures markets.

There is little macroeconomic logic behind this type of broad-based market volatility, other than wholesale systemic failure — a vicious cycle where the inability to forecast the future drives volatility, which in turn results in investors selling assets and fleeing into cash. When they simply sit on their money rather than providing liquidity by investing it, the markets can no longer operate normally.

In the short run, market volatility will dictate a change in investor psychology. In contrast to the observable strength of the U.S. labor market and the resilience of domestic demand in developed economies, the extent of China’s slowdown and emerging market fragilities is as yet unknown. Where the former factors dominated markets in the first half of the year, now the latter are in charge.

This time investors can’t look to the major central banks for solutions to the latest triggers of global financial instability. In the past month, three factors have roiled the markets: 1) China’s surprise devaluation; 2) the knock-on capital flight from emerging markets, amid stalled reforms and the political crises unfolding in Turkey and Brazil; and 3) depressed energy markets, with crude oil down more than 56 percent in the past year, below $40 a barrel. There is little that the Fed, the Bank of England, or the European Central Bank can do to prevent these developments, especially with interest rates near zero and with ample liquidity already in global capital markets. Furthermore — and on the good side of the argument — there is little evidence that China’s slowdown, the bursting of bubbles in emerging markets’ currencies, and cheap oil have had many adverse effects on domestic demand, credit flows, or labor markets in the United States, Britain, or the Eurozone.

As a result, it’s hard to tell how long-lasting, disorderly, and consequential the current volatility in the markets will be for the global economy. This creates a challenge for global policymakers, who face the unenviable task of placing a price on uncertainty where markets have failed. They have to make a judgment call between the near-term headwinds from cheaper emerging market exports and commodity prices, and the medium-term tailwinds of stronger consumer purchasing power, more efficient energy markets, and rising savings in emerging markets. None of the main sources of the uncertainty — China’s transition away from years of excessive private credit and investment growth, the rebalancing in emerging and commodity markets, and global markets’ adjustment to a new, higher-volatility regime — will dissipate soon.

For some observers, the turmoil in Chinese markets, despite aggressive efforts by the authorities to inject stimulus, raises the specter of policy failure. To them, the subsequent global markets fallout demonstrates that the enormous liquidity pumped into the markets by central banks is no fix for the global economy’s problems of over-borrowing and under-spending. The fact that the bubbles in emerging market currencies and share prices have burst, despite record injections of cash by the Fed and China’s own easing of monetary policy, is a sign that global financing conditions have been too lax for too long — not a reason for further easing.

For others, the possibility that economic uncertainty and market volatility will prompt the Fed to delay the launch of rate hikes at least until next year, and prompt other central banks, such as the European Central Bank and the People’s Bank of China, to inject more liquidity is cause for optimism that the recent disorder may be contained.

In any case, the markets appear to be preparing for more volatility — and pain — in the global economy over the coming months. The only certainty is that this fresh impetus in the policy debate about how to generate more global demand, as opposed to just more market liquidity, is a healthy development for the future.

Image credit: Andrew Burton/Getty Images