Qatar- Nine signs to watch in volatile markets

(MENAFN- The Peninsula) By Mohamed A El-Erian

The return of market volatility last week shouldn’t have come as a big surprise given the unusual economic political and geopolitical fluidity around the world. The past year has been characterised by occasional spikes in volatility either in the form of sharp asset-price gains or as was the case last week acute falls. And 2016 promises a lot more of the same which should force investors to pay greater attention to the dynamics of potential tipping points.

The central question is not whether market volatility is on the rise; it is. Rather the main uncertainty is whether these occasional spikes will prove both temporary and reversible and in particular whether injections of liquidity from both public and private sources will continue to quickly stabilise market conditions and for how long.

Here are nine aspects of the volatility question which has both financial and economic implications: Bouts of volatility are to be expected given rather sluggish global economic fundamentals national politics that are heavily influenced by anti-establishment movements and a number of geopolitical instabilities and threats. The most recent financial market instability was accentuated by the Fed’s decision to hike rates which confirmed the divergent monetary policies undertaken by the world’s most-influential central banks. Also playing a role were concerns about market accidents following the news that at least two corporate bond funds had limited investor redemptions. These bouts of volatility are amplified by fragile market liquidity caused by the rather limited appetite of broker-dealers to provide their balance sheet in a counter-cyclical manner. This phenomenon gets worse as these intermediaries get ready to close their books for the year.

Excessive volatility especially when associated with sharp downward movements in asset prices is detrimental to the real economy for three reasons: By increasing risk aversion among many investors and thus reducing the flow of capital to productive activities. By threatening the “volatility repression” approach that central banks have used to encourage greater consumption and investment. By risking the disorderly deleveraging and in some cases liquidation of over-extended investors. And through the ensuing threat of financial “sudden stops.”

Concerns about excessive volatility are a lot greater when markets approach tipping points. With economic and corporate fundamentals struggling to improve quickly enough the task of stabilisation has repeatedly fallen to liquidity injections from two sources: central banks including through the use of large- scale asset purchase programs; and companies which have deployed cash from their balance sheets to pursue share repurchases pay higher dividends and carry out mergers and acquisitions. Whenever adverse volatility is apparent some market participants are quick to call for the central bank to step in to restore calm. That occurred on Friday when some suggested the Fed should reverse the 25 basis point interest rate hike it had implemented just two days earlier. In fact it is much more likely to hike interest rates again then it is to cut them. Although other central banks will press harder on the stimulus accelerator the now-divergent stance of global monetary policy makers will provide less support to asset price repression overall. As a result more of the burden of stabilisation will fall to the deployment of corporate liquidity.

This configuration is a lot less supportive of financial markets which will operate in a higher volatility regime notwithstanding continued liquidity injections from companies and central banks even if these are at a lower level globally. With global growth continuing to slow and as some systemically important emerging economies struggle to fully stabilise we should not expect economic and corporate fundamentals to play a sufficiently deterministic stabiliser role for asset markets and that is without taking into account the effects of national and geopolitical developments.

Financial markets are now transitioning from a world in which real and perceived liquidity injections have effectively repressed volatility to a new operating regime. As a result the question for 2016 and beyond is not whether volatility bouts will be more frequent and in some cases more violent than in the last few years. They will be. The challenge will be in monitoring carefully the tipping points for various market segments along with related price overshoots and undue asset-class contagion.

Bloomberg