To shed light on one of the worst starts to a new year for global stock markets, some analysts are turning to macroeconomic explanations, such as China's economic slowdown and its uncharacteristic policy slips. Others prefer to focus on the cascading influence of unhinged markets, such as oil. Yet neither explanation is sufficiently comprehensive; and each fails to account for major changes in liquidity and volatility.
The unfavorable market impact of China's sputtering growth engine has been amplified by some unusual policy moves, including the sudden reversal in the implementation of circuit breakers for the stock market, a partial loss of policy influence over the growing offshore market for the currency and poor communication. These alone, however, don't justify the extent of the stock selloff around the world, including in the U.S., where the 8-per-cent drop in the Standard &Poor's 500 Index in the last two week was inconsistent with an economy that continues to heal.
A similar dynamic is at work in the oil market. Yes, oil prices have been undermined by the mismatch between growing supply, including from shale, and slowing demand growth. This undoubtedly has been aggravated by the Organization of Petroleum Exporting Countries' decision to abandon the role of swing producer on the downside (that is, cutting production to limit price declines). But the resulting moves in oil, and the extent to which these have contributed to the more general financial instability, have been overstated, particularly when it comes to the effects on sectors and countries that are big consumers of energy and that are benefiting from enormous windfalls.
Why then do even small changes in these variables lead to outsize moves in financial asset prices, both up and down? And why do global stock markets have a general downward bias?
Financial markets are undergoing two consequential transitions, which not only amplify the impact of even the smallest developments in China and oil, but also increase risk aversion overall and create the conditions for more unpredictable developments.
The first has to do with the shift from a prolonged regime of repressed financial volatility to an environment in which such instability is higher and less predictable. The primary reason is that central banks are less willing (in the case of the Federal Reserve) or less able (in the case of the European Central Bank and the People's Bank of China) to act as suppressors of volatility. In the short term, this transition inevitably leads to higher risk aversion, deleveraging and lower portfolio risk-taking, especially affecting risk-based models and asset allocations that use volatility as a major input.
The second transition involves liquidity, and a move away from counter-cyclical balance sheets. Facing tighter regulation and sharply reduced market appetite for short-term earnings deviations, broker-dealers are a lot less willing to take on inventory when the market overshoots. Other pools of capital, including sovereign wealth funds, also face constraints in increasing their risk-taking.
Left unchecked, these two transitions would feed each other, accentuating the general sense of financial instability and insecurity. The longer this continues, the greater the volatility and the bigger the threat of adverse consequences for economic and corporate fundamentals; and the higher the risk that the instability could then spill back onto financial markets, fuelling a destabilizing vicious cycle of economic and financial dislocations.
The good news is that such dynamics ultimately exhaust themselves. Unfortunately, that only happens after a lot of volatility, accompanied by a heightened risk of very sharp and disorderly declines in financial asset prices as well as contagion. In the process, that turmoil has a contractionary influence on corporate and household spending, slowing economic growth.
A much better resolution would be if improving fundamentals could support and validate financial asset prices, which also would provide the context for the productive engagement of the large amounts of cash now held on the sidelines, whether on companies' balance sheets or in excess household savings. Policy adjustments will be needed for this to occur, and, this time, the response cannot be the sole responsibility of central banks in general (and the Federal Reserve, in particular).
Indeed, even if the Fed were to resort to a new program of large-scale securities' purchases ("QE4"), the measures' economic effectiveness would be in great doubt from the outset unless they were accompanied by pro-growth structural reforms, more responsive fiscal policy and the removal of entrenched debt overhangs.
Neither of these outcomes is preordained. What happens next depends on choices that will be made in the weeks and months ahead, particularly by politicians who, through inaction and partisan bickering, have placed too much of the policy burden on central banks for far too long.
Mohamed A. El-Erian is the chief economic adviser at Allianz SE, chairman of Barack Obama's Global Development Council and the former CEO and co-chief investment officer of Pimco.