To shed light on one of the worst starts to a new year for global stock markets, some analysts are turning to macroeconomic explanations, such as China’s economic slowdown and its uncharacteristic policy slips. Others prefer to focus on the cascading influence of unhinged markets, such as oil. Yet neither explanation is sufficiently comprehensive; and each fails to account for major changes in liquidity and volatility.
The unfavorable market impact of China’s sputtering growth engine has been amplified by some unusual policy moves, including the sudden reversal in the implementation of circuit breakers for the stock market, a partial loss of policy influence over the growing offshore market for the currency and poor communication. These alone, however, don’t justify the extent of the stock selloff around the world, including in the U.S., where the 8 percent drop in the Standard & Poor’s 500 Index in the last two weeks was inconsistent with an economy that continues to heal.
A similar dynamic is at work in the oil market. Yes, oil prices have been undermined by the mismatch between growing supply, including from shale, and slowing demand growth. This undoubtedly has been aggravated by the Organization of Petroleum Exporting Countries’ decision to abandon the role of swing producer on the downside (that is, cutting production to limit price declines). But the resulting moves in oil, and the extent to which these have contributed to the more general financial instability, have been overstated, particularly when it comes to the effects on sectors and countries that are big consumers of energy and that are benefiting from enormous windfalls.
Why then do even small changes in these variables lead to outsize moves in financial asset prices, both up and down? And why do global stock markets have a general downward bias?
Financial markets are undergoing two consequential transitions, which not only amplify the impact of even the smallest developments in China and oil, but also increase risk aversion overall and create the conditions for more unpredictable developments.
The first has to do with the shift from a prolonged regime of repressed financial volatility to an environment in which such instability is higher and less predictable. The primary reason is that central banks are less willing (in the case of the Federal Reserve) or less able (in the case of the European Central Bank and the People’s Bank of China) to act as suppressors of volatility. In the short term, this transition inevitably leads to higher risk aversion, deleveraging and lower portfolio risk-taking, especially affecting risk-based models and asset allocations that use volatility as a major input.