This Market Selloff May Be Different
Stock markets were beset by interest-rate jitters on Friday, making it the worst day for the major U.S. averages since late June.
Every one of the 10 Standard & Poor’s sectors ended in the red, and bonds and commodities also had a bad day. The backdrop to the selloff was recent developments indicating that consensus market expectations have attached too low a probability to a Federal Reserve interest-rate hike this year, as I have argued.
The generalized move down in stocks is sparking an interesting discussion about how investors should respond. After all, we have experienced such sudden air pockets in the last year. These events have been rather infrequent given the context of unusually low market volatility, and all have proved both temporary and quickly reversible.
Whether this equity market selloff will follow the same course is, of course, open to debate. Already, some are urging investors to “buy the dip,” hoping to repeat a strategy that has proved profitable in the past. Other commentators are more cautious, and some have suggested that investors should sell before prices fall even further.
Where you end up on this issue has less to do with your assessment of corporate and economic fundamentals than with how you see the prospects for a continuation of the recent exceptional period of both public and private liquidity support for financial markets. Specifically:
- It is unlikely that fundamentals will improve significantly any time soon. International Monetary Fund Director Managing Director Christine Lagarde signaled last week that the IMF is again likely to revise downward its forecasts for global growth, a confirmation that the world economy remains fragile and uneven. The sputtering of structural and cyclical expansion engines is being accompanied by highly unbalanced macroeconomic policy responses, including the prolonged excessive reliance on central banks, weak global policy coordination and an inability to translate good policy intentions into effective improvements.
- Politics and geopolitics aren’t helping. The political context in many Western countries is far from conducive to good and calm economic policy: The U.S. is in the final stretch of a contentious presidential election; in the U.K., the consequences of the Brexit vote in June have yet to become clear in terms of policy and institutional changes; Italy is facing its own defining referendum; Spain is struggling to form a government, and in Germany, the governing party of Chancellor Angela Merkel suffered a humiliating local election defeat to the anti-establishment AfD party. Geopolitics also add uncertainty, including a defiant North Korea, continuing turmoil in the Middle East, as well as the threat from non-state actors, lone wolf attackers or terror groups, which amplify a sense of new unpredictability.
- The usual antidotes to such market episodes are no longer as much of a certainty. These economic, political and geopolitical factors are not new. Indeed, until now, the winning trade has been to shrug them off, including by assuming that the occasional selloff will be both temporary and reversible. The main reason is not that stock valuations have been ultra-cheap. They have not. It is that downward trends have been more than offset by liquidity injections, particularly those from share repurchases by corporations, including those with large amounts of cash on their balance sheets, and unconventional central bank policies that have involved sizable asset-purchase programs. Such liquidity injections, and the incremental market demand that comes with them, have delivered to investors a lot more than a boost in asset prices. They have consistently repressed volatility, encouraging many to take on more market exposure for each unit of allowable risk. And they have reduced the drag to risk-mitigating portfolio diversification. That’s because both stocks and bonds have benefited from these purchases, thereby helping simultaneous price increases for both risk assets (such as stocks and high-yield bonds) and “risk-free” ones (such as U.S. and German government bonds).
Those, like me, who worry about an excessive decoupling of stock prices from fundamentals also feel that the dominating impact of liquidity may be changing and potentially waning. This is particularly the case for central banks, whose market intervention is evolving because of a change in what former Fed Chairman Ben Bernanke described as a “benefit, cost and risk” equation. The shift is not just a matter of the declining benefits of protracted unconventional monetary measures — characterized by less central bank policy economic effectiveness overall, as well as the Bank of Japan’s experiment with negative rates, which has been not just ineffective but also possibly counter-productive. This evolution is also the result of (justified) mounting concerns about collateral damage and unintended consequences, especially when it comes to the detrimental effects of ultra-low and negative nominal interest rates, distortions to the healthy functioning of markets, mounting threats of future financial instability and central bank vulnerability to political interference. Such considerations have underpinned signals from central bank that they are becoming more reluctant to do more absent a notable deterioration in economic activity. This became more evident last week when the European Central Bank refrained from specifying additional policy actions. It may also have influenced the remarks by Boston Fed President Eric Rosengren on Friday that highlighted the markets’ excessive discounting of the possibility of rate hikes.
- The private antidote may also be less notable from now on. Stocks have benefited from enormous corporate cash injections, including $1.7 trillion in U.S. stock repurchases from 2012 through 2015, according to Goldman Sachs data cited in a recent Financial Times article. The windfall for investors has been amplified by consistently higher dividend payments. Now, however, there are partial indications that slowing growth in both buybacks and dividends may become less of a potent force. According to Bloomberg data, average corporate cash cushions have shrunk to their lowest in three years as earning growth slows. The appetite of companies for financial engineering, including issuing bond to fund buybacks, may also be restrained by rising yields and uncertainty about future prospects.
All of this means that markets will again try to force central banks into a round of supportive liquidity injections and an even more protracted period of ultra-low interest rates. And there is no definitive reason to expect that they won’t succeed. But the longer-term prospects of such a strategy are becoming weaker by the day; and the more companies realize this, the lower the prospects for higher corporate buybacks and dividend payouts.
Without a significant improvement in fundamentals, investors would be well-advised to remember that there is an impending limit to how much liquidity injections can protect markets from the underlying economic reality.