Even the most resilient markets can crumble under pressure, as we have seen from the volatile start of 2016. Markets have been buffeted by instability and further government intervention in China, plummeting oil prices, geopolitical jitters and concerns that the global economy will grow even more slowly than forecast, with very little bounce in global inflation.
Unforced policy errors?
As 2016 got underway, China introduced, and then suspended, circuit breakers that were designed to limit intraday stock market volatility. Each major slide in Chinese share prices during the year’s opening week was led by a drop in the Chinese yuan. Many investors appear concerned that China is joining the so-called currency wars — devaluing its currency in order to spur export competitiveness. Others, however, counter that the Chinese currency remains quite strong on a trade-weighted basis. China recently announced a shift in policy that will target a basket of currencies, rather than the bilateral exchange rate against the US dollar.
One thing is clear, however: Weakness in the yuan prompts greater capital outflows from China, which in turn prompt greater currency weakness, resulting in a classic negative feedback loop. What is also clear is that market participants have lost a great deal of faith in the ability of Chinese authorities to manage an increasingly complex economic and market landscape.
Fears of policy mistakes extend beyond China. Many question the decision by the US Federal Reserve to tighten monetary policy — despite the fact that financial conditions had already tightened considerably in advance of the December rate hike. Conditions began to tighten in the wake of the Fed ending its asset purchases in late 2014, and have tightened further on the heels of a strong US dollar. US growth appeared to slow significantly in the fourth quarter of 2015 and inflation remained extremely low, so the need for a rate hike was not obvious. Notably, the VIX index, which measures implied volatility on the S&P 500 Index, began spiking within days of the rate hike.
And since the Fed cited global economic and financial developments as a rationale for delaying a hike that many expected last September, there is speculation that it could do so again in 2016. Since the Fed hiked policy rates in mid-December, long-term rates have actually fallen, illustrating that there are still serious concerns about the economic backdrop. The recent market turmoil has prompted financial markets to trim expectations for the number of Fed rate hikes this year. Given the jump in market volatility and the erosion in the geopolitical backdrop, a further hike at the March Federal Open Market Committee (FOMC) meeting is now seen as far less likely than it was just three weeks ago.
Geopolitical concerns have also begun to weigh on global markets. In early January, North Korea appeared to have tested a nuclear device — an indication that it remains unfazed by China’s efforts to restrain its nuclear ambitions. Geopolitical tensions are mounting too in the Middle East, as Saudi Arabia and Iran intensify their cold war.