If 2018 was the first year that assessed the flexibility of global markets to a shift from quantitative easing to quantitative tightening; the results did not instill faith. Investors began the year unprepared for the renewed volatility that came as the Federal Reserve rolled back more of its insurance liquidity.
The evidence of a strong US jobs market and historically low policy rates could not prevent US stocks having their worst December since 1931 proved that a decade of repressing volatility had left the market with a feeble immune system. The paramount issue facing markets now is where the fresh clearing level for risk remains.
Has recent turbulence reset market principles to more sustainable levels, or does it portend greater anxiety to come? The answer rests in the crossover of two powerful themes that befuddled investors in 2018. On the one hand, there was a wholesale derating of equity and credit risk assets, and a parallel tumble in Treasury yields as investors sought liquidity and capital conservation. On the other, and in stark contrast, is the solid US economic expansion, with double-digit earnings growth and the lowest unemployment rate in half a century.
As was the case a decade ago, liquidity conditions in markets have become dislocated from the state of the real economy. And this tug of war between enhanced market fragility and underlying economic resilience means that seeking to find a new level for risk assets is chasing a moving target. For a US economy running near full capacity, with import constraints and skills shortages placing curbs on the pace of future expansion, a further demand-driven stimulus is superfluous. Rising labour costs and further import tariffs may still produce a late-cycle inflationary tailwind.
Combine that with a $1tn fiscal deficit projected for 2019, and political pressure for more infrastructure spending, and it is problematic to see why US “equilibrium” rates should be any lower below current Fed funds levels. While the fundamental picture remains strong, however, it is the
market turbulence that has in recent weeks dominated the debate about the Fed’s tightening cycle. The outbreak of volatility over the past year demonstrates that the swift advance of algorithmic and passive strategies, which helped spawn the relentless buying that inflated stock valuations in recent years, has shifted orientation.
As spikes in volatility spread, and with the three-month US dollar Libor at the highest since the global financial crisis, the repricing of risk has shifted the principles of portfolio volatility and liquidity management. The end of predictable markets in 2018 — and the out-performance of cash – marked a stark reversal of the “QE forever” that prompted earlier correlated gains across asset classes. One risk now is that tighter market conditions become self-fulfilling.
The intrinsic vulnerability exposed by the shift to quantitative tightening raises the spectre that financial volatility contributes to vulnerability in economies, via negative wealth effects, higher debt refinancing costs and diminishing confidence.
The experience of recent weeks indicates that disorderly market volatility can come far quicker and carry much greater harm than one looking just at economic fundamentals can anticipate. If markets’ capacity to re-price risk malfunctions at a cyclical peak in earnings growth, how extensive will the pain be when substantial economic weakness unfolds?
As Fed chairman Jay Powell acknowledged last Friday, avoiding market tensions would simply add unnecessary risk and complexity to the economic outlook. Markets dependence on the Fed for liquidity means safeguarding against a catastrophe requires nimble policy governance and the capability for surgical interventions when systemic stresses develop.
Whilst slowing the Fed’s balance sheet withdrawal could help investors rebuild their portfolios’ resilience for a world of more normal interestrates, volatility and growth, without inflicting outsized damage on the economy.
Finding the equilibrium for a stainable macro-economic system will be the policy test of the next decade. The Fed’s duty of boosting the
economy out of the last crisis is now accomplished. The policy test to avert the next, albeit very distinct, crisis has just commenced.