Now that the dust has settled, it is clear last month's stockmarket correction began when US equity investors finally realised the inevitable consequences of returning to more normal levels of interest rates and yields.
This led to a chain reaction triggered by derivatives-based investments with returns tied to and geared around low levels of volatility. When volatility exceeded certain thresholds, those products become forced sellers to cover their exposures, while more fundamentals-based (human) investors were unwilling to buy their excessive volumes, given how expensive stocks had recently become.
By opting against ‘dip-buying’, liquidity suddenly evaporated amid the biggest one-day jump in volatility ever recorded. The decline in liquidity coincided with a drop-off in activity from the single biggest buyer of equities since the global financial crisis, corporates themselves, with their share buyback programs.
Investors now have to decide what is likely to happen as a consequence of this violent dislodging of the previous order. Stockmarket earthquakes tend to be followed by further tremors. Volatility can then lead to a fundamental market reassessment by investors, leading to a break from the previous trend. Finally, the sell-off itself can create a negative feedback loop into the real economy, with the potential to disrupt the previous economic balance or trend.
The consensus view, which I share, is the global economy is in a more stable period of synchronised growth than it has been for a very long time. This is most likely going to continue, albeit at a slightly slower rate of growth than seen of late.
But we cannot be as certain how capital markets will trade from here in light of the end of the goldilocks environment of strong corporate profit growth and low cost of capital. Unfortunately, it's possible the market upset creates a new economic reality in which the reduction of capital market driven liquidity, together with the already reducing central bank provided liquidity, leads to an economic slowdown which sours capital markets more fundamentally.
Back to 'normal'?
While February’s shift was unnerving for investors, it also triggered a fascinating debate among economists and market strategists about where we are headed.
There is a growing consensus the ‘new normal’ era we’ve experienced since the global financial crisis is coming to an end. As one of our research partners put it: “The world is not on the verge of returning to the inflationary 1970s but the mediocre and choppy economic landscape, combined with no inflation and hyper-accommodative monetary conditions, is gone. The same is true of the heady days of ever-falling interest rates and yields, and ever-rising asset prices”. But here’s where the disagreements start.
The bears argue higher debt volumes make the global economy so vulnerable to rising yields and interest rates that the return of even mild inflation of around 2 per cent marks the end of this economic cycle.
The bulls, on the other hand, suggest this cycle is only just getting started. They see this as a return to the ‘old normal’, with companies at last deploying their plentiful capital to expand through higher productivity, rather than relying on short-term ‘hire and fire’ staffing strategies. This should quell inflationary pressures from staff shortages, as capex investment-driven productivity helps push down labour costs even as wages increase. Providing this doesn’t lead to an overheating of economic conditions, we could hope for a smooth transition from the goldilocks era of cheap capital to the next goldilocks era of productivity gain-driven growth.
However, such transitions rarely occur in straight lines. This is especially true when capital markets have never before experienced such an extreme shift from extraordinary interventionist measures back to more normal factor costs of funding, labour and capital investment.
The most pressing concern is either the central banks or bond markets overshoot from one extreme to the other, causing a credit squeeze that triggers a renewed economic slowdown. Of the two, it’s more probable that central bankers will remain level-headed, which should keep bond markets operating in an orderly way and delay the end of this economic cycle for some time to come.
Yet as we continue the transition from one ‘normal’ environment to another, there are plenty of opportunities for market forces to lose orientation and temporarily lose faith in the longer-term growth path.