January was an unusual and exciting month for financial markets.
Volatility returned to the equity markets. To use a rather unsophisticated measure, almost three-quarters of the trading days showed moves of more than 100 points in the Dow Jones Industrial Average. Yields on higher quality government bonds plummeted; 10-year Treasuries ended the month at 1.64 percent and Germany’s 10-year rate touched a record low of 0.298 percent. Meanwhile, the foreign exchange markets were marked not only by notable fluctuations in currency values but also by changes in exchange rate systems for stability-obsessed countries such as Singapore and Switzerland.
Many of these developments reflect the effect of “divergence” — that is, large and persistent deviations among systemically important countries when it comes to economic performance and monetary policy prospects. In the absence of comprehensive policy responses and limits on interest-rate differentials, this variance continued to place an enormous burden on currencies, forcing them to essentially become the major shock absorbers. And, as history has shown us, movements in the foreign exchange markets — especially large ones — have consequences for other markets.
Developments in the foreign exchange markets have already spilled over. In the latest earnings season, several companies cited currency movements as powerful negative forces. Meanwhile, as many international stock market investors left their currency exposures unhedged, it was inevitable that foreign exchange losses would translate into negative developments in equity funds.
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Adverse contagion was also generated by the sharp movement in oil prices, as the market continued to adjust to a fundamental change in supply conditions (namely, the de facto withdrawal of the Organization of Petroleum Exporting Countries — and Saudi Arabia in particular — as the swing producer). The falling prices forced energy companies to rush to cut capital expenditures. Poorly managed oil producing countries, such as Russia and Venezuela, experienced deteriorating credit quality and a concurrent sharp rise in risk spreads.
This heightened sense of instability was compounded by political and geopolitical events. Elected just a week ago with a commanding mandate, it hasn’t taken long for the new Syriza government in Greece to signal that it is serious about seeking an alternative way of handling the country’s debt — a development that is far from comforting for its European neighbors, the European Central Bank, the International Monetary Fund, as well as Greece’s bank depositors and foreign private sovereign bond holders. Meanwhile, the economic and financial implosion of Russia has been accompanied by an escalation of violence in Ukraine and aggravated political tensions between President Vladimir Putin and the West.
The more instability, the greater the threat to the low volatility economic and market environments engineered by central banks, which have played an important role in boosting asset prices, accelerating financial healing and buying time for politicians to get their act together and come up with comprehensive and lasting policy approaches.
Repeated spikes in market volatility tend to sideline retail investors. In some cases, positions will be closed if an asset’s inherent volatility exceeds predetermined thresholds. Even the most sophisticated investors are inclined to scale down their positioning in the context of higher multifaceted volatility.
Another discomforting aspect of this uncertainty is the extent to which the volatility has occurred despite the continued engagement of central banks. In January, the ECB took unprecedented steps to expand its involvement in markets, committing to a sizable and almost open-ended asset purchase program. The Bank of Japan has pursued a pedal-to-the-metal stimulus approach. Even the Federal Reserve, which has decided to slowly scale back its quantitative easing program, reiterated its intention to be “patient.”
The most critical question about the markets’ behavior in January is not “why?” but “so what?” And answering that question could well be consequential for markets, which had benefitted enormously from central bank activism intended to create the conditions for a combination of accelerated private sector healing and a more comprehensive policy response from governments.
Although the internal healing is occurring, progress on the policy front has been frustratingly slow in most advanced countries. This is particularly true of structural reforms that enhance productivity, dynamism and entrepreneurship; creating an aggregate demand configuration that does a better job in matching the willingness and ability to spend; the easing of pockets of excessive indebtedness that inhibit economic recoveries; and, in the case of the euro area, progress toward completing an economic union based on more than just monetary integration.
The broader implications of January will be determined by policy makers in the advanced world. If they continue to delay progress toward a more comprehensive policy approach, the world will experience an increase in the risk of financial instability that would then undermine economic performance and render policy management even more complex. That, in turn, would make the subsequent recovery even more difficult.
Policy makers don’t have much time to waste to ensure that the setbacks of January don’t turn out to be harbingers of what lies ahead for markets and the global economy.
Mohamed El-Erian is chief economic adviser at Allianz, chairman of President Obama’s Global Development Council and the former chief executive officer and co-chief investment officer of Pimco.
© 2015, Bloomberg News