Financial markets are driven by animal spirits.
Sentiment among market participants can quickly turn from bullish euphoria to bearish pessimism – and back again. This is normal.
Typically, the ups and downs of markets do not have much of an impact on the broader economy, but from time to time major trends in one direction or another can matter.
After sustained strong gains in 2017 on the back of synchronised global economic growth, equity markets in the advanced world have experienced major swings in 2018.
Following two major market sell-offs, in February and in October, European equity markets have fallen by around 10% year-to-date, while US stocks have largely moved sideways.
From time to time, major trends in one direction or another can matter
On their own, equity market sell-offs do not typically show up in economic data much.
Scary charts coupled with strong adjectives on the front pages of the newspapers may deter spending for a day or two, but as long as the market settles down, things should get back to normal quickly.
However, when the market does not settle, but continues to switch foot – as in 2018 – we need to ask two questions: what is causing the swings in markets, and what are the implications?
Today, two key trends are causing problems for investors: the global upswing has lost momentum and is no longer synchronised, and political risks have grown.
In 2017, the three titans of the global economy – the US, the eurozone and China – all grew at a decent clip. The US and the eurozone enjoyed growth well above the average of prior years.
Rising profits and confidence pushed the valuations of risky assets, such as equities, higher.
This year, while US growth has remained strong thanks to the expansionary fiscal policy favoured by President Trump, both China and the eurozone have lost momentum.
Some controlled deleveraging in China and the fallout from the US-Chinese trade war have exacerbated a slowdown in Chinese demand growth that may well be more pronounced than the country admits in its official GDP statistics.
Markets struggle to grasp the extent to which China’s problems may be structural rather than cyclical.
Meanwhile, an unusually potent cocktail of risks – trade wars, Italy, Brexit and elevated oil prices – has restrained eurozone growth.
Amid this divergence, global demand for safe US assets has grown. In 2018, the dollar has recovered most of the 12% loss that occurred in 2017 when risk-on investors dared to search beyond the US for high returns.
Financial markets can be a harbinger of major changes in economic momentum. But for now, the chance the softness in markets could, on its own, restrain economic growth significantly is small.
When the rises in asset prices are coupled with excessive gearing, such that the fall in the values of assets exceeds the value of the associated liabilities, this can have strongly negative balance sheet and wealth effects that can matter. This is not a major risk today.
After more than nine years of the post-Lehman recovery that started in the spring of 2009, advanced economies have not yet developed any of the serious credit, investment or inflation excesses that would require a cleansing recession any time soon.
As a result, the risk that the weakness in equity markets could cause a temporary economic slowdown to turn into something more sinister remains small.
It would take a very pronounced financial shock to cause a major economic slowdown.
Next year, the fading of some political risks, stronger gains in real disposable incomes at stable rather than rising oil prices and a lesser drag from net exports will allow eurozone GDP growth to rebound.
Meanwhile, Chinese policymakers have started to turn on the taps bit by bit to stimulate demand growth. Eventually, China will stabilise and markets will relax about such risks.
On balance, we need to brace ourselves for some further volatility in global markets and weaker economic data in the eurozone near term.
Trade tensions, Brexit, Italy and even German politics look set to make further headlines. It may also take a little time for China worries to fade.
But, unless the political risks were to get out of hand, the soft markets are unlikely to be the prelude to a major global downturn.
With luck, along with continued firm growth in the US, improving fortunes in the eurozone and China can support a return to risk-on mode in markets.
Kallum Pickering is senior economist at Berenberg Bank
This article was taken from the December 2018/January 2019 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership